Ever since Benjamin Graham spelled out the principles of value investing and demonstrated their potential to improve returns and reduce risk—this was during the Great Depression, after all—investors around the world have been crunching numbers, trying to determine if the companies they’re interested in are undervalued or overvalued. If it’s the former, they might buy the stock; if it’s the latter, they’ll stay away.
Recently, though, valuation decisions, which typically start with a look at the price-to-earnings ratio (P/E), have been put to the test. Over the past five years, the P/E multiple on the S&P 500 has climbed by 55%. The index is now trading at 20.2 times earnings, which, other than during the recession, is the highest it’s been in a decade. Numerous companies, especially dividend-paying ones, are trading well above their historical averages.
This has caused many fund managers to stretch their definitions of “value” and make excuses as to why they’re buying seemingly expensive stocks. Those who would once have stayed away from equities trading at, say, 20 times earnings are now blithely buying them. That’s caused concern among value investing stalwarts. But others see it as an overdue reassessment of some increasingly outdated measuring sticks.
One of those revisionists is Mitchell Goldberg, president of ClientFirst Strategy, based in Melville, N.Y. Metrics like P/E and price-to-book are subjective tools that never mattered as much as most investors thought they did, he says. Whether a P/E is expensive or not depends on the way a manager chooses stocks. “It’s like abstract art,” Goldberg says. “We could both look at a drawing, and I can say it was created by a child and you can say it’s a Picasso. It’s the same thing with valuations.”
Furthermore, macro factors currently at play make these metrics even less relevant, he argues. Barely-there interest rates, made possible by unconventional monetary policy since the last recession, have driven investors into dividend-paying products, and that has pushed P/Es higher. Investors aren’t paying attention to anything other than whether a company is stable and is paying a yield.
The risk-free rate of return, or the interest on a three-month treasury bill, is a measly 0.3% today, Goldberg notes. If someone wants to earn 5% on their investments, they’ll have to buy securities that come with a considerably higher risk. If interest rates rise and push that risk-free rate of return higher, then those dividend stocks and high-yield bonds are vulnerable. Not knowing which way interest rates are headed makes the old metrics useless, Goldberg says. “With interest rates at nearly zero, or even negative, valuations could rise forever. The goalposts keep moving.”
Travis Miller, a utilities sector analyst with Morningstar, agrees that more and more market participants are just looking at the cash returns a stock can provide. They’re seldom using valuations to consider how far a stock could drop if rates rise or the market in general declines. Typically, companies with low valuations fall less than ones with high ratios. “That’s the real conundrum here,” he says. “It’s the yield paradox, where cash returns appear very strong going forward, yet capital losses could offset that if interest rates start climbing.”
Miller maintains that P/E still matters. Ultimately, investing is about the return you want and what you’re willing to pay for it, and in a world of negligible interest rates, people have to pay more to get their desired return. Miller uses the example of someone who borrows money at 5% to invest in a stock. He or she might buy a $100 stock that will pay a $5 dividend, which would then cover the 5% loan. But if the rate changed and it now cost 10% to borrow, the investor might only pay $50 to get that $5 dividend.
The P/E ratio gives investors an indication as to whether the price they’re paying matches up with the return they need. Take that 5% cost of capital and divide it by the share price, and you get 20 times, meaning you’ll have to pay 20 times the cost of capital to get a fair return. If the rate is 10%, you’d only be willing to pay 10 times. This is why Miller thinks P/E remains important: If rates jumped, then P/Es would contract and the prices people would be willing to pay for stocks would fall.
Today’s high valuations in a time of tepid economic growth are particularly vexing for professional investors constrained by certain rules, says James Harper, a portfolio manager for the Templeton Global Balanced Fund. They may be restricted to U.S. stocks, for instance, while many firms in Europe are trading below their historical norms. Retail investors have more leeway. Still, there is a temptation to abandon one’s past investing style when higher P/E stocks outperform lower ones over multiple years, as they’ve done lately, Harper says.
Ultimately, investors need to come up with their own ways of valuing stocks. Some people swear by P/E and price-to-book; others, like Goldberg, think neither makes a lot of sense. He’d rather see companies increasing revenues year over year, bringing on new contracts, reinvesting in the business and planning for the future. He’s happy to pay a higher P/E if the company appears to be moving in a positive direction.
Valuation ratios are increasingly subjective; they only mean something insofar as you know how the future will unfold, he contends. “There’s no such thing as normal anymore,” Goldberg says. “For someone to say valuations are higher or lower than normal is not something I would subscribe to.”
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