Most of our readers don’t need to be convinced of the importance of factoring stock valuations into their investment decisions, but that doesn’t mean value investor necessarily agree on how best to go about it. Price to earnings (PE) is one of the most popular metrics, but according to Goldman Sachs’ portfolio strategy team, the best tool depends on which sector you’re looking at what part of the business cycle it’s in.
“Using valuation to select stocks is effective at both the index and sector level but different valuation metrics should be used to pick stocks depending on sector,” write Goldman Sachs analysts Stuart Kaiser, David J. Kostin, Amanda Sneider, and Ben Snider. “The proper valuation choice also changes based on each sector’s sales, margin, and EPS cycles as well as broad-based US economic growth.”
ISM gives a rough indication of which valuation to use
They say that a good rule of thumb is that when the economy is expanding with an ISM above 50, stock pickers should focus on EV/EBITDA or forward PE, but when ISM drops below 50 then FCF yield has better performance, with only consumer staples and energy breaking the mold.
But a more sophisticated approach looks at a variety of factors including sales growth, operating margin, EPS growth, and ISM to decide which valuation metrics are most important. A lot of the time this will mean taking more than one valuation metric into account, but you should probably be doing that anyways just to make sure that you aren’t cherry-picking the metric that fits your biases.
“For instance, P/B is the best valuation metric when Info Tech margins are falling but the worst metric when margins are rising,” explain Kaiser, et al. “Picking Industrials stocks using P/E is very effective when sales growth rises but that is not the case for the Materials, Energy, Consumer Staples or Info Tech sectors.”
Dividend yield is the worst valuation metric to rely on
Even if you’re skeptical of backtested results, it’s interesting to compare the relative returns of different valuation tools across sectors. Cash flow yield, PE, and EV/EBITDA had the best returns going back to 1980, and the only sector where FCF and PE don’t seem particularly useful is energy where a combination of EV/EBITDA and P/B gives better results. The study found that the worst valuation metric to use across the board is dividend yield (a slightly odd inclusion to the list) which not only underperformed the market but actually had negative returns in half the sectors in the S&P 500 (INDEXSP:.INX).