By Jack Forehand, CFA, CFP® (@practicalquant) —
There has been a lot of talk in recent years about the market’s valuation. And much of that talk has been centered around how expensive it is. You won’t find me arguing with many of those takes, since I have said similar things myself. But it is also important for all of us who look at and interpret valuation data to understand what we are getting and what it means.
There are many metrics that can be used to look at market valuation. There are also many different ways to use those metrics to calculate whether the market is cheap or expensive. And those different approaches can sometimes lead to very different conclusions.
As is the case with all things in investing, market valuation data requires all of us to dig into the details to understand what we are getting and to question the biases of the person presenting it to us.
To illustrate this, I thought it would be interesting to take a look at some charts of the current market valuation and why each of them can lead to different conclusions.
But before I do that, just a quick aside on how to calculate a market PE ratio.
Common Valuation Errors
Many investors (and some professionals as well) think that calculating the average PE ratio of a portfolio or index of stocks is just a matter of averaging the PE ratios of the stocks within it. That isn’t the case for two reasons.
First, the weighting of positions is very important in the process. In other words, if you look at a market cap weighted index like the S&P 500, the valuation of the largest companies is much more important to the overall index than the smallest ones. Therefore, performing a calculation that treats them all equally doesn’t make sense.
Second, to calculate the PE ratio of a portfolio of stocks, you cannot just use a weighted average all their individual PEs. The details of this are beyond the scope of this article, but in general, this calculation requires something called a harmonic mean which involves converting PE ratios to earnings yields before calculating portfolio level metrics. So the first step in evaluating market valuation data is just simply to make sure it was calculated correctly.
Different Metrics, Different Results
But even data that is calculated properly can lead to very different conclusions.
Here is a chart of the S&P 500 CAPE ratio (which uses 10 years of earnings).
It paints probably the exact picture you would expect it to paint. It shows that the market is the second most expensive it has ever been (with the exception of the dotcom bubble).
Now here is a chart of the S&P 500’s trailing twelve-month PE ratio.
It still shows a market with an expensive valuation relative to history. But it also shows a significant reduction in the PE ratio in recent years. This is a function of the fact that this chart only uses one year of earnings instead of ten. Earnings have been very strong since the 2020 market decline, and that has much more impact on the trailing twelve-month PE than the CAPE.
One of the things we like to do at Validea is to look at the valuation of the median stock. A median is calculated by simply sorting all stocks by the variable you are looking at, and then taking the data point with equal data points on either side of it (the middle one). This type of analysis is essentially useless in looking at a market cap weighted index like the S&P 500 for the reasons I talked about earlier. But it does give you a reasonable idea of the valuation of the typical stock out there. For investors like us who build equal weight portfolios, it can provide more information than the valuation of market cap weighted indexes.
Here is what the median trailing twelve-month PE ratio of our investable universe (about 3000 stocks) looks like.
It is in the 43rd percentile since 2006, meaning that the median stock is actually cheaper than the average over the period. How can that be given what we just talked about? It is a function of the fact that the largest stocks are currently more expensive than the average stock. A median calculation will reflect that relative to a mean calculation for a market-cap weighted index.
Does this mean your average stock is cheap? Well, not exactly.
Here is the same median calculation using Price/Sales instead of Price/Earnings
Well, that looks a lot worse. 93rd percentile historically. The reason is that margins are near all time highs right now. Whether you feel those high margins are sustainable will provide the answer as to which chart might be more correct.
But that isn’t the only potential issue. There is also another issue going on behind the scenes with a median PE ratio calculation. That issue is that there are significantly more companies that lose money right now than there were at the beginning of the period in the graph. Companies with negative earnings do not have a PE ratio and therefore get excluded from the calculation. Some argue this distorts the calculation.
What happens if you add them back into the calculation, but treat them the same you would as the highest PE stocks?
This is what happens.
The situation ends up much like the Price/Sales chart and we once gain have a very expensive market.
The Reality of Valuation
So what does all of this mean? The goal here isn’t to suggest that the market is expensive, or that it isn’t. The goal also isn’t to advocate a particular calculation for figuring that out. My point is that the key to understanding the validity of market valuation data is to understand the details behind it because this data is often presented by people who are using it to support a particular point of view.
I could easily have written an article about why the market is very expensive and used the charts above to support that conclusion. I also could have written one about why the market is cheaper than many think and used the median PE ratio chart from above. Neither would be wrong, but both would lack the complete picture. As is the case with many things in investing, with valuation the devil is often in the details.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.