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Many investors feel that the U.S. equity market is overvalued. Some even question whether the massive monetary infusions around the world have created an equity bubble. Fortunately, classic warnings of a bubble seem to be missing. And while typical calculations do show significant overvaluation, it appears equities are less overvalued than they seem.

Valuing the market

Price-to-earnings (P/E) ratio

One of the most common valuations — the P/E ratio — simply divides the last 12 months earnings of an index, like the S&P 500, into the current price. Using third quarter earnings and December’s closing price, the S&P 500 P/E ratio would be 22.5 times earnings. Since 1980, that ratio has averaged just over 17 times earnings, which indicates that the S&P 500 currently sells for 32% more than “normal.” That ranks the current P/E in the 86th percentile of its range since 1980.

A loss of 32% would certainly be a major drop, and that merely brings valuation back to average. If prices fell to the cheap range of historic valuations, the losses would be even greater. On the positive side, however, losses of that magnitude are nowhere near the 80 – 90% drop that bursting bubbles have incurred.

Using the Shiller P/E ratio to adjust for cyclical effects

The elevated level of profits as we near the peak of the cycle may also make the trailing 12-month P/E look more reasonable than it would seem at other times. For just that reason, Dr. Robert Shiller proposed using an inflation-adjusted 10-year average P/E to control for cyclical distortions. Since most economic cycles last less than 10 years, the longer time frame should smooth out cyclical variations.

Data from Dr. Shiller’s website show that the S&P 500 stood at 33 times the 10-year average of his adjusted earnings in December. Since 1980, the mean for that statistic was roughly 22 times earnings, putting the current valuation approximately 52% over the average. That ranks in the 92nd percentile of the range since 1980. It is also worth noting that without Shiller’s inflation adjustment, the overvaluation drops closer to 40% over the average.

The valuation impact of rising profit margins

While the Shiller analysis makes an adjustment for cyclical changes in profitability, it does not adjust for significant changes across time. From the late 1970s through the mid-1990s, the S&P 500’s profit margin (excluding extraordinary items) ranged from a low of roughly 4% to a high of just over 6%, averaging around 5%. Starting in the mid-1990s, however, that margin gradually rose to 9% (10% if interest and taxes are not subtracted).

Reasons cited for the increase include declining effective tax rates, reduced costs of borrowing, reduced cost of labor through improved technology, and savings from sourcing products overseas. Some of these, such as the cost of borrowing, will likely reverse in whole or in part. Others, including cost savings from technology, are more likely to be maintained—or even extended—with time. If the higher margins are sustainable, improved profitability should be factored into valuation.

Using the price-to-sales (P/S) ratio to adjust for profitability

Earnings are a function of sales and margins, so the P/S ratio can help gauge how much the S&P 500 should be valued for various levels of profitability. The P/S ratio currently stands close to 2.1 times sales. The average going back to 1955 is slightly below one, with a previous high of approximately 2.2 times and a low around 0.5 times.

Paying 0.85 times sales for a profit margin of 5% is mathematically equivalent to paying 17 times earnings. If the S&P 500 currently declined to 0.85 times sales, it would fall about 60%. Alternatively, a profit margin of 10% would justify a price of 1.7 times sales. At that profitability, the S&P 500 is selling just 23% above where it “should” be selling.

Implications

When properly valued, current valuations will look expensive relative to valuations in periods when the asset was markedly less profitable. At 23% over the long-term average, the market still seems overvalued, but that is much cheaper than typical valuation methods indicate.

The real question is whether current profitability can be sustained. The majority of the rise in profitability seems to come from sources that should be reasonably stable. In addition, analysts generally expect the recent tax act to improve corporate profitability. And the continuing potential for improved technologies in the workplace presents another argument for higher margins in the future. On the other side of the ledger, competition always has the potential to erode margins over time.

The time frame for changes in profitability is critical, since major changes do not occur quickly. It took roughly 20 years for margins to increase to this level and it could easily take a decade or more for other significant changes to develop. That is good for investors. As long as margins do not deteriorate sharply over the next few years, the S&P 500 seems more reasonably valued than many investors think.

About Bruce McCain

Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com. Bruce joined a predecessor of Key in 1987, after spending six years on the business faculty of the University of Iowa’s Henry B. Tippie College of Business. Bruce earned a PhD in Business Administration from the University of California at Berkeley, and undergraduate degrees in Psychology and Accounting from Boise State University.

Disclosures

Investment products are:

NOT FDIC INSURED NOT BANK GUARANTEED MAY LOSE VALUE NOT A DEPOSIT NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not give legal advice.