Whether equities are expensive or not depends on how you look at it
Head of Equity Strategy
Summary: US equities look expensive when measured against itself but when the equity valuation is mapped to future returns the current levels could still provide investors with a positive real return over the next 10 years. If the question of equity valuation is broaden to that of against government bonds, also called equity risk premium, then US equities look historically cheap. In today's equity note we also explain why cash flows matter more than earnings and why investors should focus on free cash flow yields instead of P/E ratios.
During internal discussion about equity valuations and whether the market is expensive or not we thought it was about time we made a guide to equity valuations and what really matters when looking at companies.
The rebound in US equities have pushed our valuation model back to being 1 standard deviation expensive using seven different valuation metrics since 1995. Measured against itself the equity market looks increasingly expensive. Using only P/E in which we have data going back to 1954 the market is 1.1 standard deviations expensive or 30% above the average (and this is before the expected decline in EPS in the second half).
But a certain valuation level measured against itself has no meaning or value unless it is tied to future returns. Based on 10-year realized US equity returns less inflation (also called real return – an increase in purchasing power or real wealth) we can map our valuation metric to the future and there the picture looks a bit different. There is an estimated 60% probability that the 10-year annualized real return will be positive. This means that the risk-reward ratio is not certain that you will increase your real wealth in equities over the next 10 years. But important point here is that equities measured against itself looks expensive and most would be inclined to reduce equity exposure or even sell everything but history suggest that even at current levels the investor can get a positive return adjusted for inflation.
One of the biggest drawbacks of making absolute equity valuation comparisons are that the underlying system of companies constantly changes (technologies, accounting rules etc.). This means that we are not exactly comparing the same thing. Companies were easy to compare before the 1960s as most of them were an industrial type company with large capital expenditures and a local revenue stream. The accounting rules were simple, and everyone agree to value equities based on dividends. Since the 1960s the network of companies has changed dramatically.
The first wave was larger national companies and increasingly offering consumer goods relying on marketing and brands. This grew the importance of intangible assets on the balance sheet something that had previously one been an artifact of acquisitions of companies above book value. Later companies became more international and cross-border accounting rules had to be established. Then came the IT companies which had little capital expenditures, large profit margins and no real production. Making comparisons of equity valuation since 1890 which many commentators do including the famous Shiller P/E also called CAPE ratio (cyclically adjusted price-to-earnings ratio).
In the period before the 1960s the prevailing view among investors was that stocks should be bought for its income, in other words, investors were looking for stable dividends. Growth was viewed as risky and hazy. During the growth decade of the 1960s investment banks began making IPOs based on growth narratives with the big boom starting among retailers that were expanding to become national instead of regional. Over time equities have become a growth component for investors in their portfolios and not an income component. This has created a drift upward in P/E ratios (regime change if you will) which is the key reason why we do not go back further than 1990s when do historical comparisons of equity valuations.
We have established the rationale for tying absolute equity valuation with itself to future returns, but one could argue equities do not live in isolation. They interact in a complex system with other assets and investors constantly re-evaluate these assets and how to mix them to fulfill their objectives. The typically alternative to equities are government bonds which are viewed as the risk-free interest-bearing asset offered by the government. The historical outperformance of equities vs bonds is called the equity risk premium. That is the premium the investor earns for assuming risk beyond the risk-free asset.
Aswath Damodaran is a finance professor at NYC and is one the leading equity valuation experts and he has long-term data on the US equity risk premium. As the chart below shows the US equity risk premium today is quite attractive in a historical context driven by the very low yields offered on US government bonds. There are many ways to estimate the equity risk premium as one can read in Damodaran’s paper Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2020 Edition. The classical way was to use the dividend yield and earnings yield approach. However, the couple of decades less than half of earnings are now paid out as dividends meaning companies in aggregate terms are expanding their cash balances. These funds can be used to buy back the companies’ own shares which is exactly what has happened over time.
To better estimate the risk premium Damodaran has moved to FCFE model (free cash flow to equity) which captures the overall cash flows available to shareholders. Free cash flow to equity is essentially the net income less the accumulation of fixed assets (capital expenditures minus depreciation) minus changes in non-cash working capital plus the net change in debt. This is the cash flow that is available after all capital sources needed to run the business (fixed assets such as factories, suppliers, and debt holders) have been paid. This cash flow can be returned to shareholders via two channels: dividends or buybacks of own shares with the latter being the most tax-efficient solution for a multinational company.
Therefore, free cash flow is so important and the reason we often mention it. Most investors learn about P/E ratios, but they are insufficient as they cannot be compared if the capital structure is different or the business model is different. Earnings are also easier to manipulate than cash flows. The chart below shows the results from a machine learning model on various factors and how they explain outperformance for a given stock. The Shapley values show that a high value (red colour) of free cash flow yield pushes the model towards a positive output (predicting outperformance against the overall equity market). The model also shows that the low debt leverage (net-debt to EBITDA) has a positive impact on outperformance.
In other words, companies with a positive industry outlook, high free cash flow yield and low debt leverage have better risk-reward ratios for the investor. Next time you look at a company think in terms of free cash flows and compare it against the enterprise value of the company and not the market value. The enterprise value is the market value plus net debt; this is the takeover value for another company that wants to buy the company. The free cash flow to enterprise value is the real yardstick for valuation and the one private equity investors are also looking intensely at when deciding on their investments. The free cash flow yield combined with the revenue outlook was also the reason why Facebook was on our list last week of reasonable valued technology companies. If the investor just looked at the P/E ratio of 28x then it would have scared most people off but cash flows and earnings are not the same due to accounting rules and because of they are recognized over time.