Fisher Investments Reviews the Usefulness of Stock Valuation Methods

Transcript

Ken Fisher:

So with markets up, and this is not uncommon, price-earnings ratio of the market—price of stocks in aggregate divided by the earnings of companies in aggregate— is at very high levels. And a lot of people looking forward and sometimes calculated this way, sometimes calculated that way. A lot of people just see that as a sign that stocks have a bad future ahead. Could be. Could be not. Let me help you a little bit of that.

Now first off, price-earnings ratio can be calculated multiple ways. Valuations can be calculated in ways that aren't price-earnings ratio like price- to-book or price-to-cash flow, price-to-EBITDA, price-to-sales, that I largely created decades ago, now commonly used. But the reality is that none of these valuation tools— and I've done a lot of work on this, I've published a lot of work on, scholarly work on this years ago, and it's still true today— none of these are useful in predicting stock returns one, three, and five years into the future by any measure.

But I don't think it's so much because of the negative interest rate environment. I think it's because value will become a stronger part of the market than it's been. Some of that will be because of the global function of central banks starting to cut rates, at whatever level they do it, whenever they do it. I don't want to speculate about that. You never speculate successfully about what central banks will do because they never know what they'll do. They just do.

Arguably today, the most famous one of them is the CAPE Shiller PE. The CAPE Shiller PE looks at ten-year normalized price earnings ratios calculated in a particular way, and shows that ten years after that, stocks tend to have below average returns. And that's been true. Not negative returns, but below average returns. That's true. But the fact is, if you take that same CAPE Shiller PE data and instead look at subsequent one, three, and five year returns, it's got a correlation to stocks of zero. Once you get that, you realize that it's not a very good forecasting tool because if the market's going to do something over ten years, but before that it does the reverse for one, three and five years. The five year is going to drive you crazy and drive you into action long before you ever get to the ten years. You follow that? And ten years later, or five years later, excuse me, five years later, the data is all different again.

Let me say this a different way that I wrote about heavily for the first time in my Super Stocks book a long time ago. If you just take the price, the simple price-earnings ratio, trailing 12-months price earnings, it's the easiest calculation to make. On January 1st of every year, going back to the beginning of reliable S&P 500 data in 1925, and look at forward one-year returns after that. You see an amazing phenomenon. And you can see this in my book. It's been true ever since. For every level of PE— high or low—there are the same number of high and low stock returns. If you take low PEs, the one, three, and five year numbers, are just as likely to be high in history, as low in history. If you take high PE numbers, the one, three, and five year numbers are just as likely to be low as high. There's just as many instances of both.

The fact is, it's a terrible forecasting or timing tool. It's never—now, now, now, now, let me slow down. We have a lot of features about who we are that derive from our evolutionary past. And if I take any information and communicate it to you in a format of heights, the higher it is, the more it tends to make you afraid. Because when we and our ancestors would fall 500 years ago, any significant distance, if we hurt ourselves, it might maim us for life or kill us. We don't have so much of that falling risk now, but fall out of a tree from 20ft and you'll find out. The fact is, we're built to have a certain amount of fear of heights. It's a rare person that doesn't have actual fear of heights. And when information is conveyed to us in a heights framework, the heights frighten us. It's one of the reasons why big numbers scare us so much. It's easier to envision falling than ascending.

Now, to see that more correctly— and I'm just trying to take you to a different level of depth here that's not terribly deep—you take the PE. Let's say the PE is ten. That would be $10 price per share divided by $1 of earnings per share. Let's say it's 20. That would be $20 of price per share divided by $1 of earnings per share. Okay? An easy way to get away from that height structure is to flip it on its head and instead of thinking of a PE, think of an E divided by P Now it's one divided by ten, or one divided by 20. One divided by 20 is 5%. When you're buying a stock with a PE of 20, you're buying a stock where the earnings is 5% of the price you're paying— this is called the earnings yield. And you're getting a 5% after tax return as if you own the whole business. Now, that business may do well or badly in the future, but the aggregate of businesses, which is the market, on average grows. The earnings over time grow. So you're getting a 5% after tax yield on the price that you paid to buy the businesses at 20 times earnings. That grows over time, which of course beats a ten year, 4% bond, which is a pretax number that you have to pay tax on, afterwards. You get a lower after-tax return on the bond.

What I'm wanting you to see is that that high number isn't so scary when it's translated into an earnings yield. If you compare it to interest rates, you get a better comparative sense of where's the value? Now somebody would say, but I right now get 5%, you know, putting money in a bank somewhere. Yeah. Temporarily can, maybe, for sure pay tax on that too. But it doesn't grow. It just keeps being the 5%, whereas the earnings of the market keep growing.

And the point is, I'm not suggesting that means that now that by itself says anything about where stocks are headed. That's not what I'm saying. What I'm saying is that that thing that seems so high doesn't seem so high if you flip it on its head, and move away from the heights framework and think singularly about what it is as an economic return compared to other economic returns.

Voice of Ken Fisher:

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