June 24, 2019 glacierinvest

This post is going to be a little more technical than what we’ve been doing over the past couple of months. I’m not intentionally trying to make it more technical but this particular analysis is a byproduct of some of the other work I’m engaged in currently and felt it was a good example of how to use asset valuations in practice.

We discussed stock market valuation here last month. As a reminder, price is not the same as valuation although they’re related. Additionally, when assessing how “expensive” or “cheap” an asset it is we usually compare it to the earnings, sales and/or cash flow the asset produces.

In several of the investment strategies we offer, valuation is one of the factors we focus on in identifying which assets to hold for our clients. We look at multiple valuation metrics but for today’s post we’re going to focus on price-to-earnings (“P/E”), price-to-sales (“P/S”) and price-to-cashflow (“P/CF”). I divided the universe of US stocks with a market capitalization of $200m and higher into deciles for each of the three aforementioned valuation metrics. In the charts below, I display the current level for each metric as well as the long-term average for each metric going back to 2002. For those that are more technical, I did not control for survivorship bias in this analysis. I’m simply looking at the stocks that exist today, going back in time, with no inclusion of stocks that no longer trade due to mergers/acquisitions, bankruptcies, etc…

It’s important to note each valuation metric has its merits and its flaws. I’m not advocating for one metric over another. As I mentioned above, at Glacier Investment we use multiple valuation metrics in our analysis as any one metric can be misleading at any point in time.

  1.  It’s interesting to note that the top decile of stocks by market capitalization not only has the highest average P/E ratio but it’s also the furthest above its long-term average. lending credence to the claim the market is top-heavy which could be dangerous for passive investors in the event of a sell-off.
  2. However, the top decile of stocks is near the bottom of the range for P/S ratio while being the second highest for the P/CF metric. Note: It’s not uncommon for valuation metrics to send conflicting signals.
  3. The bottom decile has the highest average P/S ratio while it is among the lower values on the P/E and P/CF metrics. Again, we run into conflicting signals.

In isolation, this information isn’t too useful except for conversation. Combining the valuation metrics can provide a potentially more useful narrative. However, incorporating other factors in the analysis generally provides greater clarity and hopefully better decisions.

There’s definitely a science to investing but there’s definitely an art component as well. Taking things at face value can lead to disastrous outcomes for portfolios. Combining data, strategies and best practices generally leads to superior outcomes.