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.