This article was written on September 13, 2019. For our next monthly newsletter. I did not anticipate the events of the past two weeks to evolve as quickly as they have, but the core thoughts remain very relevant.
This year the public equity markets have managed to brush off all economic and political news and continue to new highs. As of last night, the SP 500 sits at 3009.57, very close the all-time high of 3027. The SP 500 is up 20% this year, making it a very good year for investors. Few would have thought the markets to perform this well in January of this year. How did we get here? Are current valuations warranted? I will try to address these questions and others in this writing.
When one looks at valuations whether it’s on a company basis or an overall market, one’s assumptions used in their modeling is of paramount importance. We all know of the old saying “when you assume, you can often make an a** out of you and me”. What numbers one uses to build out and prove their valuation work is critical. Let’s take a look at one example:
Using the Dividend Discount Model (DDM), admittedly an old school methodology that has a conservative bias, but humor me for a moment, I am old school.
Discount Rate: 10%
YR Dividend: 57
Dividend Growth for 5 years at 3%, then at 2% thereafter
This gives a market valuation for the SP500 of +297% overvalued.
Now wait a minute, a 10% discount rate is overly bearish in a low interest rate environment, particularly with the U.S. 10 Year treasuries at 1.78%. If I use the current 10 YR Treasury rate, then the SP500 is 55% undervalued! If I use a discount rate of 5% then the SP500 is 57% overvalued. So, what is the right number? In this simple example we see how quickly one’s assumptions can greatly vary the end results. The same is true with any methodology. The cost of capital, risk free rate, or beta one is using can and will change the results significantly in their final analysis. How do we ensure that we are using the right assumptions in determining valuation? To be honest, in thirty years in the investment business I have no one right answer. This is why it is important to use several different valuation models and plug in three different scenarios, base case, optimistic and pessimistic, and compare them regularly.
There are two other models that I like to use, one being the Discounted Cash Flow (DCF), and the other being Price Comparable using P/E, P/B, P/S and P/CF. The most difficult part of the DCF method is determining the discount rate to use (much like the DDM). What is the appropriate rate to use? How does one determine this? The risk free rate commonly used is the U.S. 10 year treasury. However, this rate is a moving target and can swing wildly depending where we are in the cycle. For example, rates are very low now, will they stay there? Will they go lower? The long term 10 year bond average has been at 4.54% (since 1990). We have seen in my DDM example how sensitive the model is to the discount rate one uses. Determining the risk free rate and in the FCF model and determining the company risk component to add for an individual investment are the most difficult inputs to determine, and they can have a dramatic effect on the end result. This is why in investing QUESTIONING EVERYTHING continuously is important. Being right, proving that you have chosen correctly is not what matters. What matters is the end result, the performance. The best way to avoid large losses is to ask questions. Never assume your input numbers on your model are correct. The markets and companies are fluid and moving. Things change, and we need to be ready to adjust accordingly. The most important part of investing is being a continuous learner. Always ask questions and NEVER assume anything!
So where are we now in terms of public market valuations? On a P/E (price earnings) basis the SP500 trades on 22.4 X earnings. This is vs a mean average of 15.76X, so it’s fair to say the market is “relatively” expensive to its history. The SP500 earnings yield is 4.46% currently vs. a mean of 7.35%, also showing that it is relatively expensive to history. We are however living with extremely low rates so it’s not time to hit the panic button yet. For me it just means that I better be sure of what I am buying, the margin for error is small.
Another measure I like to look at is the Shiller-CAPE PE. While this number is very long term and will not predict any sudden changes, it has been accurate in predicting long term values. For those of you not familiar with Shiller-CAPE, a brief explanation: “The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.” Robert Shiller. Robert Shiller is a professor of economics at Yale and Nobel laureate for his work using a cyclically adjusted price-to-earnings ratio to smooth out and give a more accurate representation of the ratio. Please look at the link for the latest data for global markets based on Shiller’s model: https://www.starcapital.de/en/research/stock-market-valuation/
Bear in mind Shiller’s work is based on long-term averages, so one again just because it shows the U.S. is over-valued do not panic. It does merit consideration has the model have been very accurate over the long term. Simply put, I look at various methods, and use them a way to take the temperature of where we are in the cycle. Right now, wherever I look the market is expensive. This does not mean to avoid the market or raise cash. It simply tells me to be careful and be sure of the investments in my portfolio.
One last look with a chart from PIMCO showing where markets are relative to historical valuations. This is based on end of June data, but we are very close to the same levels today so the results would be the same.
It is interesting to note here the extreme divergence for Eurostoxx (European index). Eurostoxx is sitting in the middle of the range of their valuation range, vs. U.S. markets being at the top of their range.
Now why is all this important when managing a private equity portfolio? Afterall there is no mark to market, they are private and not influenced by the liquid trading markets most investors are involved in. In fact, nothing could be further from the truth. Public market valuations are the basis from which we determine private equity valuations. I would even argue that due to their nature as illiquid investments, they should be valued at a discount to the public markets. While there are always exceptions to this rule such as new technology or in the medical/pharma space. Remember they are exceptions, and there better be a strong case for giving a company an exception. I give you two in the news today examples of this: Smile Direct Club recent IPO just flopped. The public offering came at $23, opened at $20.55, and closed its first day of trading at $16.67. We Work another very anticipated IPO is having issues with its IPO. Current discussion in order to keep the IPO on track has reduced the price value to $15 Billion. This is down from $47 billion that was calculated for the last round of private financing earlier this year. These examples show how quickly things can change. Seeing much anticipated IPOs falter like this reminds me of the last days of the dot com bubble. In January of 2000 I began seeing deals fail, and we all know the rest of the story.
The main message of this writing is the importance of taking different valuation methodologies into account when examining a potential investment. Equally important is to be rigorous in determining the assumptions one is using for their models. By all traditional measures valuations look expensive right now. The only way I can justify current valuations is by assuming interest rates will stay very low. Now there are reasonable arguments for interest rates to stay low, but I am not quite ready to accept this as part of my base case for equity valuations. More on this in my next writing.