Valuation Matters

Economic value refers to the underlying worth of an asset. Measures of valuation come in all shapes and sizes, but share a common goal of attempting to gauge this underlying value. The most fundamental of these compare price with an assessment of the cash flow generating potential of the asset being analyzed. We look at various measures of value, many specific to particular asset classes, when developing asset allocation strategy.

While taking a moderately more aggressive stance when valuations are low has its own reward, the larger benefit of keeping an eye on valuation comes from the potential to lessen the impact of market downturns. This is not an attempt to forecast or “time” the market, but rather a recognition of what financial theory suggests and history shows. Namely, that the tradeoff between risk and return becomes increasingly more favorable as valuations decrease, and less favorable as valuations rise. 

While there are many measures of valuation, and these measures are by their very nature subjective, history has shown that even the most basic of these measures can be very instructive. The most popular valuation measure in the stock market is the price-earnings ratio, or P/E, which indicates the amount investors are willing to pay for a $1 of annual earnings. While far from perfect as a valuation measure, the P/E ratio has proven to be a very effective predictor of subsequent long-term returns, as the chart below demonstrates:

*Data from Professor Robert Shiller, Yale University; predecessors to the S&P 500 used prior to 1957.

This chart compares P/E ratios with subsequent 10-year real (inflation-adjusted) returns from 1871 through 2008 (1871-1880, 1872-1881…1999-2008). The 10-year returns were ranked according to the P/E at the beginning of the period, and divided into groups (quintiles) based on this ranking. Group 1 thus contains the 20% of 10-year periods with the lowest starting P/E’s, while Group 5 contains the 20% of 10-year periods with the highest starting P/E’s. As can be seen, there is a strong relationship between beginning P/Es and subsequent returns. The low valuation periods in Group 1, with an average beginning P/E of 8.5, had an average return of 11%, while the high valuation periods of Group 5 (average P/E of 22.6) showed subsequent 10-year returns averaging only 3.1%.

Valuation matters!