by John Manley, CFA, Wells Fargo Asset Management
“… simplify, simplify.” —Henry David Thoreau
I have always wondered why Thoreau felt the need to add the second simplify in the quote above. Wouldn’t one admonition have been enough?
I shouldn’t complain, though. His message is clear enough, and while he never would have dreamt this, it is not a bad piece of advice for the many equity market commentators who speak of stocks as being overvalued. I think they are wrong, and the reason I think they are wrong is that they overcomplicate the E (earnings) in the P/E (price to earnings) calculation. They try to normalize it.
They might use price to sales (to adjust for margin fluctuations). They might use price to book (to adjust for fluctuations in returns on equity). They might use price to trailing earnings (to adjust for our inability to properly forecast earnings). They might use price to the average of the past 10 years’ earnings (on the notion that the more history you include, the more likely it is to resemble the future). Finally, there are those who sit on the fence and use a combination of trailing and future earnings (because if you don’t trust either, you really should use both). They are all trying to adjust for the fact that we should put higher multiples on trough earnings and lower multiples on peak earnings. They are adjusting for profitability and, in the process, making the valuation metric overly complicated.
When I studied algebra, I learned that I could precisely solve a simple equation like x+5=10. However, a more complex equation such as x+y=10 could never be precisely solved because the contributions of x and y to 10 could not be precisely attributed. Was it x or y that got me much closer to 10? I could never tell.
That’s the problem with price to adjusted earnings. Is the valuation high or is it the profitability? It’s not clear to anyone. However, the price to forward projected bottom-up consensus earnings removes profitability from the equation. It is pure valuation on the best estimation of future earnings expectations we have. It is far from perfect, but there is no compelling reason to think that it is more wrong or differently wrong than it has been in the past.
This particular valuation is dead in the middle of the past 20 years. It has been a lot higher and a lot lower in that time period. In my mind, it helps explain why the equity market has neither risen nor fallen in the past two years. According to this metric, the valuation is excruciatingly fair and will need a strong push to move it higher or lower. That push will likely be earnings, and I believe that earnings will be headed higher. I think that high profitability is giving the normalizers their valuation palpitations. However, high profitability is likely not a function of what has caused such consternation in the past. It is not the product of a strong and overheated economy. Maybe it was wise to adjust those previously overheated markets for profitability. However, I think doing so today is like fighting the last war: easy to do but hard to do right.
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