Selasa, 20 Agustus 2013

Equity valuation exercises

Equity valuation is more art than science, since there are methods which produce a variety of results (e.g., stocks today are variously considered either very expensive, fairly valued, or very cheap), and no measure can claim to be an infallible method of predicting future returns. So with those caveats, what follows are some of my own methods and how they contrast to other popular methods. 

To start the discussion, you should read Jeremy Siegel's article that appeared in yesterday's FT: "Don't put faith in Cape crusaders."One of his points is that the now-famous Shiller PE ratio, which shows stocks to be relatively expensive today, might be overstating the valuation of stocks because it understates the value of earnings. He notes, for example, that accounting standards changed in the 1990s, and that had the effect of depressing reported earnings relative to the measure of corporate profits that comes from the NIPA (GDP) statistics, and making them more volatile. I illustrate that in the above chart, which directly compares NIPA profits to S&P 500 reported earnings (note that the y-axis of both series covers a similar span, with the top value being 100 times the bottom value). NIPA profits are clearly much less volatile, and the two series indeed began to diverge in the early 1990s. This backs up Siegel's assertion that Shiller's method could be improved by using NIPA profits instead of reported earnings.

John Authers argues in another recent FT piece, "From CAPE to CAPE," that reported earnings also suffer from changing taxation regimes, and he shows Alain Bokobsa's adjusted version of the Shiller PE data, which suggests that stocks today are about fairly valued.

I've long been intrigued by the Shiller PE measure, which reportedly divides the S&P 500 index by a 10-yr moving average of inflation-adjusted earnings. But either I'm obtuse, excel-challenged, or possessed of the wrong data, but for the life of me I can't come close to reproducing Shiller's PE ratios if I use inflation-adjusted earnings. (UPDATE: Thanks to reader "Jason" I've looked at Shiller's data and discovered that he adjusts both the index and the earnings—no wonder I couldn't replicate his numbers. However, I also discovered that the recent earnings he is using are about 15% below the earnings as reported by Bloomberg. That has the effect of giving his PE10 an upward bias.) Be that as it may, here are some interesting charts that use various different ways of calculating PE ratios as suggested by Siegel:

The chart above is the classic measure of PE ratios, comparing the S&P 500 index to trailing 12-month earnings, using Bloomberg's measure of adjusted earnings. This shows that stocks today are trading very close to their long-term average PE ratio, suggesting they are fairly valued.  

This next chart uses a modified form of the Shiller method: dividing the S&P 500 index by a simple 10-yr moving average of earnings with no inflation adjustment. It's normalized so that the average PE ratio is similar to that shown in the preceding chart. The conclusion is about the same: stocks are fairly valued relative to their long-term average. Using a 10-yr trailing average of earnings does indeed, as Shiller argues, reduce the volatility of PE ratios. Both this chart and the preceding one show stocks to be extremely cheap in the early 1980s, extremely overvalued in 2000, and fairly valued today.

The chart above uses Jeremy Siegel's suggestion that NIPA profits are better than reported earnings because they don't suffer from different accounting standards and because they are less volatile. Instead of dividing the S&P 500 index by a 12-month trailing measure of reported earnings, I've used the NIPA measure of after-tax corporate profits, and I've normalized the data so that the average PE is again about 16. This also shows stocks to be very cheap in the early 1980s and very expensive in 2000, but it suggests that stocks today are very cheap.

This last chart uses a 10-yr moving average of NIPA profits in a manner similar to Shiller's method. Again, the data are normalized so that the long-term average is about 16. This technique produces results that are almost identical to the previous chart, though the PEs are less volatile as might be expected.

Take your pick: according to these valuation exercises, stocks are either very cheap or about fairly valued.

I like the NIPA measure of profits, for the reasons cited above, and because NIPA profits have been calculated using actual data supplied by companies to the IRS and the same methodology throughout (this eliminates arbitrary writeoffs and adjusts for inventory valuation and capital consumption). It's arguably the best measure of true "economic" corporate profits.

So I'm inclined to view stocks as being very attractive today.

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