Absolute equity valuations enter new territory and FCF considerations

Absolute equity valuations enter new territory and FCF considerations

Equities 8 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  Global equities look expensive in absolute terms against history on both trailing and forward-looking metrics, but when they are compared against government and credit bonds the valuations look only a bit stretched. However, some pockets of the equity market such as US technology and bubble stocks look very expensive also on a relative basis and we do have real concerns at current levels that investors are paying too much for future growth. Overall, we maintain a positive view on equities.


Equity valuations measured across seven different valuation metrics have reached an all-time high in March 2021 which begs a discussion of equity valuations more generally. Are equities expensive and should we be worried?

Based on 12-month trailing valuation metrics the MSCI World Index has almost reached 2 standard deviations above the historical average since 1995. Since these metrics look back 12 months they are of course being inflated by the hit to earnings and cash flows due to the Covid-19 pandemic. The equity market is operating under high expectations that earnings will bounce back which should help the valuation index to come down somewhat. Our model of z-scores on valuations can be linked to future returns (see second chart) and here we see a downward sloping relationship indicating that higher valuations come with lower future real rate returns (nominal returns on equities adjusted for inflation). Investors are today paying prices for earnings power that have tilted the probability towards negative real rate returns over the next 10 years. But the prediction interval is quite large (> 7%-points) at these positive z-scores and thus the equity market could still from current levels generate a positive real rate return.

Equity valuations do not live in isolation

While the trailing valuation metrics are a bit distorted for a couple of quarters more, the forward-looking metrics are less impacted by sudden changes in earnings power. Here we also observe US equities and global equities being expensive in an absolute perspective with US equities close to the same levels as in 2000 during the dot-com bubble. However, with bond yields also at record low levels it is not strange that we observe high equity valuations as equities interact with other asset classes, and more specifically the bond market. The current free cash flow yield on global equities is 4.7% which is still attractive compared to the global bond market and as a result we are still positive on the equity market although the inflationary pressure could quickly change the picture.

If we compare the popular Nasdaq 100 Index with corporate investment-grade bonds, then we see that US technology stocks have been a lot more expensive in absolute terms and in relative terms to credit bonds. The current free cash flow yield on Nasdaq 100 is 2.8% and is thus much more expensive than global equities which is a result of higher profitability and return on capital, combined with much higher growth rates. The spread between the free cash flow yield and the global credit yield is coming down again to levels not seen since October 2018. This is reflecting a very strong outlook for credit quality and earnings growth driven by large fiscal stimulus. When we look at Nasdaq 100 and compare it to credit bonds and the global equity market there are reasons to begin being worried about whether investors are paying too much for future growth.

We had a listener of our podcast commenting on our free cash flow comments that we have been making over the past year. The person had two objections to our methodology, 1) we are not adjusting for stock options which are massively used by technology companies to attract talent and reduce the cash burn rate, and 2) we are not adjusting free cash flow for acquisitions which many technology companies are doing instead of investing in R&D themselves.

The objection is true, and the free cash flow should be corrected by stock options and warrants. But how big a difference does it make? Many of the largest constituents in the Nasdaq 100 Index have stock options corresponding to around 1-4% dilution of the current outstanding shares and thus including this dilution would make the metric more correct, but it would not alter the overall conclusion.

The second objection is interesting. Industry practice suggests to only subtract capital expenditures from the operating cash flow to get to the free cash flow (the cash flow that is available for acquisitions, debt reduction, buybacks of own shares, or dividends), because it is more stable and provides a more realistic picture of the underlying free cash flow generation. Large acquisition or divestments would make the free cash flow yield very volatile and clutter the analysis. The adjustment for acquisitions makes sense if an investor could expect acquisitions to be consistent, but that is very rare for most companies and as such we acknowledge the potential adjustment, but we do find it adds value for the investment decision process on equity indices.

Disclaimer

The Saxo Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-sg/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Saxo Markets
Most of our staff in Singapore are working from home to help limit the spread of the coronavirus. We remain at your service on the details below. Thank you for your understanding.

Contact Saxo

Select region

Singapore
Singapore

Saxo Capital Markets Pte Ltd ('Saxo Markets') is a company authorised and regulated by the Monetary Authority of Singapore (MAS) [Co. Reg. No.: 200601141M ] and is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms & Risk Warning to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as Margin FX products may result in your losses exceeding your initial deposits. Saxo Markets does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Markets does not take into account an individual’s needs, objectives or financial situation.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-sg/about-us/awards.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website are not intended for residents of the United States, Malaysia and Japan. Please click here to view our full disclaimer.

This advertisement has not been reviewed by the Monetary Authority of Singapore.