Tuesday, August 20, 2013

Equity valuation exercises

Equity valuation is more art than science, since there are methods which produce a variety of results (e.g., stocks today are variously considered either very expensive, fairly valued, or very cheap), and no measure can claim to be an infallible method of predicting future returns. So with those caveats, what follows are some of my own methods and how they contrast to other popular methods. 

To start the discussion, you should read Jeremy Siegel's article that appeared in yesterday's FT: "Don't put faith in Cape crusaders."One of his points is that the now-famous Shiller PE ratio, which shows stocks to be relatively expensive today, might be overstating the valuation of stocks because it understates the value of earnings. He notes, for example, that accounting standards changed in the 1990s, and that had the effect of depressing reported earnings relative to the measure of corporate profits that comes from the NIPA (GDP) statistics, and making them more volatile. I illustrate that in the above chart, which directly compares NIPA profits to S&P 500 reported earnings (note that the y-axis of both series covers a similar span, with the top value being 100 times the bottom value). NIPA profits are clearly much less volatile, and the two series indeed began to diverge in the early 1990s. This backs up Siegel's assertion that Shiller's method could be improved by using NIPA profits instead of reported earnings.

John Authers argues in another recent FT piece, "From CAPE to CAPE," that reported earnings also suffer from changing taxation regimes, and he shows Alain Bokobsa's adjusted version of the Shiller PE data, which suggests that stocks today are about fairly valued.

I've long been intrigued by the Shiller PE measure, which reportedly divides the S&P 500 index by a 10-yr moving average of inflation-adjusted earnings. But either I'm obtuse, excel-challenged, or possessed of the wrong data, but for the life of me I can't come close to reproducing Shiller's PE ratios if I use inflation-adjusted earnings. (UPDATE: Thanks to reader "Jason" I've looked at Shiller's data and discovered that he adjusts both the index and the earnings—no wonder I couldn't replicate his numbers. However, I also discovered that the recent earnings he is using are about 15% below the earnings as reported by Bloomberg. That has the effect of giving his PE10 an upward bias.) Be that as it may, here are some interesting charts that use various different ways of calculating PE ratios as suggested by Siegel:

The chart above is the classic measure of PE ratios, comparing the S&P 500 index to trailing 12-month earnings, using Bloomberg's measure of adjusted earnings. This shows that stocks today are trading very close to their long-term average PE ratio, suggesting they are fairly valued.  

This next chart uses a modified form of the Shiller method: dividing the S&P 500 index by a simple 10-yr moving average of earnings with no inflation adjustment. It's normalized so that the average PE ratio is similar to that shown in the preceding chart. The conclusion is about the same: stocks are fairly valued relative to their long-term average. Using a 10-yr trailing average of earnings does indeed, as Shiller argues, reduce the volatility of PE ratios. Both this chart and the preceding one show stocks to be extremely cheap in the early 1980s, extremely overvalued in 2000, and fairly valued today.

The chart above uses Jeremy Siegel's suggestion that NIPA profits are better than reported earnings because they don't suffer from different accounting standards and because they are less volatile. Instead of dividing the S&P 500 index by a 12-month trailing measure of reported earnings, I've used the NIPA measure of after-tax corporate profits, and I've normalized the data so that the average PE is again about 16. This also shows stocks to be very cheap in the early 1980s and very expensive in 2000, but it suggests that stocks today are very cheap.

This last chart uses a 10-yr moving average of NIPA profits in a manner similar to Shiller's method. Again, the data are normalized so that the long-term average is about 16. This technique produces results that are almost identical to the previous chart, though the PEs are less volatile as might be expected.

Take your pick: according to these valuation exercises, stocks are either very cheap or about fairly valued.

I like the NIPA measure of profits, for the reasons cited above, and because NIPA profits have been calculated using actual data supplied by companies to the IRS and the same methodology throughout (this eliminates arbitrary writeoffs and adjusts for inventory valuation and capital consumption). It's arguably the best measure of true "economic" corporate profits.

So I'm inclined to view stocks as being very attractive today.


Benjamin Cole said...

Very interesting.
Maybe stocks are undervalued---but with reason. Been a tough 14 years or so for owning stocks.
And with the Fed set to taper down...
The world's central banks still piously pontificating about inflation.

Public agencies ever fight the last war, trumpeting an exalted mission stattement...caveat emptor.The central banks have a squeamish aversion to prosperity.

Jason said...

Hi there, been following your blog for years and really enjoy your commentary. Not sure if you've seen Shiller's data but he posts/updates it here:


Scott Grannis said...

Thanks for the link, but I'm still perplexed. Shiller's earnings do not match at all what I get from Bloomberg. For example, his March '13 earnings are 14% less than Bloomberg's, and that appears to be repeated throughout the series, thus giving his PE10 an upward bias. Even the level of the S&P 500 index is different from Bloomberg's, though not hugely. Also, I note that he adjusts both the S&P 500 index AND the earnings for inflation, which is an unnecessary exercise, since the same inflation factor is present in both numerator and denominator.

Given this, I'm comfortable with my decision to ignore inflation and focus on NIPA profits.

theyenguy said...

Jesus Christ, operating in the Economy of God, Ephesians, 1:10, has completed the corporate profit, global growth and trade, part of the Business Cycle, having fully expanded the world central banks’ monetary policies, and the potential of the speculative leverged investment community, to produce peak stock wealth, VT, peak nation investment, EFA, peak small nation invetment, IFSM, peak major currencies, DBV, peak emerging market currencies, CEW, and thus peak fiat money, based upon world wide policies of investment choice, and credit schemes of all types.

Global Producers, FXR, seen in this Finviz Screener, rose 0.8% today; but as a group are now trading lower from their August 1, 2013, high.

Today, Tuesday August 20, 2013, was a good day to go short the 30 ETFs, seen in this Finviz Screener; ... http://tinyurl.com/mn83835 ... well 29 ETFs and 1 stock, which is a proxy for life insurance companies; as in a bull market one buys into dips, and in a bear market one sells into pips.

Over the last month; these have traded as follows:

GNW, -9%, a proxy for life insurance companies.

UJB, -7

TAN, -7

IBB, -5

XTN, -5

XOP, -4

RZV, -4

RWW, -4

PBS. -3

SMH, -3

PSCI, -2

XRT, -2

PSP, -2

SPHB, -2

PBJ, -1

PJP -1

IAI, -1

RXI, -1


XIV, +4

EUFN, +3

FDN, +2

CARZ, +1

IGV, +1

FPX, +1

PPA, +1

FLM, +1

BJK, +1

FXR, -0-

IGN, -0-

Hans said...

When economists and governmental units are telling you this is a good time to invest your monies you are in grave danger.

This is a phony recovery and it is in it's late stages and soon we will enjoy the recession of 2014 or 2015.

All we need is NORMAL interest rates, NORMAL federal deficits and we shall experience a NORMAL recession.

Jean-Pierre Deslandes said...


A pleasure to read you Scott, as always. In a world submerged by insignificant bloggers and pundits yours is one of the rare opinions I pay attention to. Don't comment much but never fail to read you. You've been a precious guide through the crisis. Many thanks...

Benjamin Cole said...

DJIA below 15k on taper fears...is the Fed the Bank of Japan?

Call it the BoJ lite version.

The PCE deflator at 1% and the Fed is tightening...

Scott Grannis said...

Jean-Pierre, thanks!

William said...

Ed Yardini August 20th:

"The US Treasury released data last Thursday tracking international capital flows for the US through June. The outflows out of US securities was shocking. Especially troubling was the amount of US Treasuries sold by foreigners. Their outflows exceeded those from US bond funds. Of course, some of the outflows from the bond funds could be attributable to foreign investors. Nevertheless, the data suggest that foreign investors may have been more spooked by the Fed’s tapering talk in May and June than domestic investors.

As the US federal deficits have swelled, the US government has become more dependent on the kindness of strangers. Apparently, they are losing their interest in helping us out with our debts. Consider the following TIC data:

(1) Total securities. During June, foreigners sold $934.1 billion (annualized) in US Treasury bills, notes, and bonds; Agency bonds; corporate bonds; and US equities (Fig. 1). Over the past three months, the annualized net capital outflows from these securities was $462.8 billion (Fig. 2).


Scott Grannis said...

It's worth keeping in mind that if foreigners actually are net sellers of US financial assets (something we really don't know at this point despite these statistics), then the dollars they "take home" will have to be spent on US goods and services. This is how the balance of payments works. So it's not necessarily a bad thing that foreigners are selling US bonds.

Hans said...


I see little value, nor few bargains, even q stocks are badly overpriced..