This post is co-written by Elliot Turner and David Doran
There’s been a great conversation in the blogosphere specifically about the validity and predictive power of Cyclically Adusted P/E Ratios (aka CAPE) and more generally about the valuation of US equities. The incredible run of the last year has only made the valuation debate more important. John Hussman has been one of the more vocal advocates on the Bearish side, while the pseudonymous @JesseLivermore from the Twittersphere has done an outstanding job deconstructing CAPE. In doing so, @JesseLivermore has highlighted why CAPE might not be relevant along with presenting an alternative way to look at valuation.
We think indicators like the CAPE offer valuable information, though they can never be looked upon conclusively. Further, we think that no one indicator has any worth outside of context. In an effort to simplify, context is often underappreciated in the investment community.
One key area where CAPE fails to ascertain the context is how it thinks about the valuation of businesses. Since the CAPE deals with P/E, it is purely a reflection of the price of a security, relative to its earnings power. This ignores capitalization, and as such, presents a considerable problem for comparison across time. Consider: a company that trades at $100 per share with $10 cash/share and $0 debt/share that earns $10 in net income/share vs a company that trades at $100 per share with $0 cash/share and $10 debt/share that also earns $10 in net income. On a P/E basis, both companies trade at a 10 P/E, though both companies are not “worth” the same. Assuming all else is equal, the company with a net cash position of $10/share is clearly worth more to the equity holder than the company with $10/share of debt.
For this reason, some turn to the market’s Price to Book ratio, or the Tobin Q in order to gain insight from the relationship between the market price and companies’ asset value. In fact, Eugene Fama in his studies on market efficiency long ago documented that a low P/B has high predictive power for outsized returns. While Fama was specifically referencing individual securities, it is reasonable to conclude that buying the market at lower P/Bs should thus lead to higher returns than buying at high P/Bs.
As of today, the market’s P/B is similarly situated to where it was when the 1990s bull market began in 1995. It is below the average P/B of the last 24 years and right at the average of this timeframe if you exclude the 1998-2001 bubble years. While not at extremely low levels, the P/B is near the low-end of its range of the prior 24 years. While some may argue CAPE is better at incorporating the mean-regressing nature of the market than P/B, book value itself is a slow-moving metric and gives us a sense of where the tangible worth of businesses stand. Further, changes in book value are far less volatile than changes in earnings, and as a result, book value offers investors a more stable arbiter of value. Altogether, P/B tells a very different story than CAPE.
We do not want to take the extra step of concluding whether the market is fairly priced, cheap or expensive in today’s environment. Instead, our goal is to lay out an additional concept–implied growth–as another contribution to the CAPE Debate, show where the bar is set in terms of future expectations, be slightly suggestive as to which way we lean, but ultimately leave it to you the reader to decide and opine on whether the market’s estimation of implied growth is fair or not. That being said, we do think it’s a stretch to call today’s valuations extreme. The numbers implicit in today’s market price are rationalizable when viewed in the proper context and compared to historical levels of growth, cost of capital and returns.
Earnings and Book Meet at Implied Growth
Looking at P/B in conjunction with CAPE certainly provides better context, and consequently, better predictive power for investors; however, in our opinion, we felt there were still limitations to this approach. What if there were a way to look at earnings relative to book? A way where earnings and book value could be used together to get a sense for where the market’s valuation stands? We could look at ROE over time, which is reflective of the relationship between P/B and P/E, but that datapoint alone looks like the definition of a random walk.
One thing we could do is invert (start with a certain datapoint and work backwards), to figure out what we really want to know: at what level of market valuation can I expect the best future return? There is a formula which allows an investor to figure out what the P/B ratio for a given security should be, if you know the ROE, Implied growth (g), and cost of capital (r). This formula is a derivation of the Dividend Discount Model, which is based on the incontrovertible principle that an asset is worth the sum of its discounted future cash flows.
Justified P/B = (ROE- g) / (r – g)
For the purposes of the market, it turns out, we can actually plug in every single one of these variables to the equation aside for the growth rate. This is extremely valuable, because then we can adjust the formula to solve for what the level of implied growth is, given ROE, cost of capital and P/B. This is an extremely useful metric because it will tell us what level of earnings growth the market is pricing in at this current moment in time. We can then compare our current data point to implied growth historically to provide context. Using the context, we can then judge whether the market is being too optimistic or pessimistic.
As of today, here is the information we know:
Market’s P/B = 2.58
ROE(10 year average)=13.62%
r (WACC) = 7.91% (We have used the Equity Risk Premium as estimated by Aswath Damodaran and added it to the 10 year Treasury yield. See our discussion on WACC below)
When we plug these numbers into the equation above and solve for g, we get a result of g=4.31%.
It’s important to define what exactly this number means. When we talk about growth, we are talking about the implied growth rate of underlying earnings, which means this number is inclusive of the net effect of equity issuance (repurchases). In other words, if companies in aggregate were net issuers of new shares, then this would be a drain on future growth; conversely, were companies to repurchase shares this would be accretive to future growth.
One of the shortfalls of CAPE analysis that @JesseLivermore astutely pointed is how today and yesterday are not exactly the same. Making matters yet more complex is that no two datapoints in the marketplace are stationary on even an intraday basis. The world is dynamic and things change fast. This is but one reason why we like looking at implied growth. Implied growth does something for us that neither CAPE nor any other