In some cases, the future payment is simple, like a bond that promises to pay a lump sum of $100 ten years from today. Pay $38.55 for that bond today, and you can expect a 10% annual rate of return on your money. Pay $67.56 for that bond today, and you can expect a 4% annual rate of return. Pay $82.03 and you can expect a 2% annual rate of return over the next decade. The more you pay today for an expected future amount, the lower your implied rate of return. Conversely, given any “required” rate of return you seek on your investment, you can work backwards and figure out the “present value” that you’re willing to pay.
In some cases, the future payment is complicated, like an option that promises to pay you the difference between the price of a stock and some “strike price,” provided that the actual price gets past the strike price in the next few months. For that security, you have to compute the payoff that the option might deliver at every price beyond the strike price, multiply each of those values by the estimated probability the price will get to that particular point, and then discount everything back to present value. To simplify all of that, option pricing models make various assumptions about probability distributions, volatility, and other considerations.
But simple, or complex, or anywhere in the middle, an investment security is nothing more, and nothing less, than a claim on some expected stream of future cash that will be delivered into the hands of investors over time.
In practice, few investors want to estimate a whole stream of future cash flows, so they take shortcuts. Those shortcuts, however, are entirely dependent on the assumptions one is willing to make. Suppose you have a security that is expected to produce a very smooth stream of future payments over time, growing at some constant rate. In that case, the current payment is really all you need to value the security because it is representative of the whole stream. On the other hand, if the current payment is not representative of the whole stream, you’re in trouble.
That warning applies to price/earnings ratios, price/10-year earnings ratios, price/forward earnings ratios, and virtually every other valuation measure that takes any shortcut whatsoever. Treat your “fundamental” as representative when it’s not, and it doesn’t matter which measure you’re using – you’re going to get a misleading estimate of valuation.
Applying a seemingly “reasonable” price/earnings multiple to cyclically elevated earnings is a repeated mistake, and is unfortunately exactly the same one that I waved my arms to warn about in 2000 (“One of the hard lessons that investors will learn in the coming quarters is that technology stocks are actually cyclicals”) and 2007 (“You wouldn't buy a lemonade stand by extrapolating the profits it earns in August”) – to no avail.
In our own work, we rely on a broad range of valuation measures. Many of them embed various adjustments to capture the fact that earnings, dividends and other value-drivers are often not very representative of the entire future stream. A few very simplified models that still have a near-90% correlation with actual subsequent market returns are presented in Investment, Speculation, Valuation and Tinker Bell. Because the Shiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) is simple to calculate and broadly quoted, I often mention it in these weekly comments – at least it has the virtue of being less vulnerable to year-to-year swings in earnings over the course of the business cycle. But our work is emphatically not driven by the Shiller P/E, our valuation approaches gofar beyond the Shiller P/E, and even the Shiller P/E is at best a shorthand measure of market valuations.
To understand our deeper concern, it’s important to focus on the word “representative.” Any valuation measure like “price/X” is only useful to the extent that X is representative of the very long-term stream of future cash flows. As I’ll detail below, the problem at this moment is that profit margins are about 70-80% above their historical norms; there is a century of history (including the experience of the most recent decade) to demonstrate that elevated profit margins have always normalized over time; we know why they normalize over time; and we already observe pressures that are likely to force this sort of normalization over the coming 2-4 years.
Continue reading here.