“To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life.
When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household.
When hamburgers go up in price, we weep.
For most people, it’s the same with everything in life they will be buying — except stocks.
When stocks go down and you can get more for your money, people don’t like them anymore.”
– Warren Buffett, “The Wit and Wisdom of Warren Buffett,” Fortune (Nov. 19, 2012)
So should we sing or weep? Warren Buffett has a brilliant way of making the complicated simple. Let’s think about valuations like we think about the price of hamburgers and see if we are going to get more or less for our money. Today, I share with you my favorite valuation charts and story them in a way I hope your clients might better understand.
When I speak to advisors and investors, I use Warren’s hamburger analogy. Heads nod. Eyes are locked in. People get it. If I talk about price-to-earnings ratios (P/E), price-to-sales ratios, price-to-book ratios, eyes glaze over. People don’t get it. I’m sure you understand the finance language, but a lot of people don’t. So for now, let’s talk hamburgers.
We didn’t have all of this big data or computing power in my early days with Merrill Lynch in 1984. But we do today. What you’ll see in the data that follows, the hamburgers are richly priced. We’ll define what that means in terms of the probable returns over the coming 7, 10 and 12 years and what it means in terms of the relative risks.
As a quick aside, if you are a long-time reader, you’ll know I update the charts the first week of each new month. I do it because, even after all these years, it helps me stay centered and I hope it helps you as well. Hamburgers: expensive or cheap.… What follows is a summary of the most current equity market valuations and what they tell us about probable forward returns and downside risk.
Grab a coffee and read on. I truly hope you find the messaging in such a way that your retail client can better understand. Please let me know your thoughts.
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Included in this week’s On My Radar:
- Valuations and Forward Equity Market Returns
- Charts of the Week
- Fed Policy and Rising Rates
- Trade Signals – Ride, Captain Ride Upon that Mystery Ship
- Concluding Thought and Personal Note
Valuations and Forward Equity Market Returns
Following are a number of my favorite valuation metrics. Let’s take a look at them and see what the research data might tell us about probable forward returns (high-priced or low-priced hamburgers):
Chart 1: Median P/E (Price-to-Earnings ratio). The 52.8-year fair value is 16.9. The current median P/E is 24.1. Current state: “Expensive hamburgers”
Think of the P/E ratio like this. Your business has 10,000 shares outstanding and your current share price is $10. That means your company is worth $100,000 (10,000 x $10). Now, let’s say your company earned $20,000 over the last 12 months. That works out to $2 in earnings for every share of outstanding stock ($20,000 in earnings divided by 10,000 shares). So if your stock price is $10 and your current earnings per share is $2, then your stock price is trading at a P/E of 5 (or simply $10 divided by $2 equals 5). It is simply a metric to see if your “hamburger” is expensive or inexpensive.
With this as a basic starting point, we can then see if the hamburgers are expensive or inexpensive. We can look at the S&P 500 Index (a benchmark of “the market”) and we can measure what the average P/E has been over the last 52 years – call that “fair value” or a fair price for a hamburger.
What you’ll see is that a P/E of 5 is a really inexpensive hamburger. Now I believe in you and I believe you can grow your company’s earnings over the coming years but, wow, if I can buy a great company at a low price, the odds are I’m going to make a lot of bank on my investment in you.
We can collectively look at the market as if it was a single company and gauge how expensive or inexpensively priced stocks are at any point in time. Over the last 52.8 years, the median fair value for the S&P 500 is a P/E of 17. That means a fair price for your company would be $2 in earnings times 17 or $34 per share. If I can buy your stock for $10 per share instead of a fair value of $34 per share, good for me.
But what if you earn $2 per share and your stock price is trading today at $48.20 per share or 24.1 times your earnings, I’m buying a very expensive hamburger. So price relative to what your company earns is a good way for us to see if we should sing or weep.
Here is how you read the following chart:
- Median P/E is the P/E in the middle, meaning there are 250 companies out of 500 that have a higher P/E and 250 that have a lower P/E.
- The red line in the middle section shows you how P/Es have moved over time (updated monthly).
- The green dotted line is the 52.8 year median. So a Median P/E of 17 is the historical “fair value.” Simply a point of reference.
- You can see that over time, the red line moves above and below the dotted green line.
- If you remove the 2000 to 2002 period in time (the “great bull market”), we currently sit at the second most over-valued time since 1964 (note 1966 marked a secular bull market high to be followed by a bear market that lasted from 1966 to 1982).
- In the bottom section of the chart, you can also see Ned Davis Research (NDR) marks “Very Overvalued,” “Overvalued,” “Undervalued” and “Very Undervalued.”
One last comment on the above chart. At the very bottom of the chart, NDR shows that the market is 7.9% above where it would consider the market to be overvalued.
- Meaning the market would need to decline from the March 31 S&P 500 Index level of 2362.72 to 2176.07 to get to the “overvalued” threshold.
- It would need to decline to 1665.72 to be get to “fair value.” That’s a drop of 29.5%.
- Also note “undervalued,” which could be achieved in a recession (-51.1% away).
So fair value for your company would be $34 per share (that’s your $2 per share in earnings times a “fair” P/E of 17). But your company is trading at $48.20. I’d be happier if your hamburger were priced at $34 for I’d make much more on my money. I’d be thrilled if your stock was at $20, my forward returns would likely be outstanding. Let’s look at what that looks like next.
Chart 2: Median P/E and Forward 10-Year Returns
Median P/E can help us predict what is likely to be the coming 10-year