The sCAPEgoat: Why Valuations Get More Attention Than They Deserve
Nick Maggiulli comes out with a timely post on the subject of valuations when investors world over are questioning the future of value investing. Nick for one doesn’t debunk value investing either – indeed his post on margin of safety last year (see here) emphasises the importance of price in any investment decision i.e, price should be below the intrinsic value with a margin of safety. What he questions here though is the ability of PE (or for that matter, even a more credible Cyclically Adjusted PE (CAPE)) to determine the intrinsic value. For starters, he demonstrates how PE is at best a relative measure of value – relative to other similar markets or stocks or for the more evolved, relative to its own historical averages. It is not an absolute measure of value either way – “For example, is a CAPE of 20 high or low? It isn’t either. It’s just high or low relative to what people have paid historically. That’s it. If investors collectively decide that they want to pay more for the same amount of earnings going forward, then what used to be considered “high” is now normal. As economic circumstances change, so will peoples’ willingness to pay more (or less) for stocks.” Whilst Nick’s arguments are at the market level, similar arguments for the shortcomings of the use of PE as the last word on valuation can be made for single stocks as well – PE fails to capture the extent of future growth, the longevity of growth nor the volatility of growth. See our July newsletter here for more on the subject of longevity of growth. In a separate blog from earlier this year, Morgan Housel comes at it from the point of investing time horizon – longer the horizon less the effect of starting PE on eventual returns, beautifully bringing out the fact that PE multiples DO NOT compound but earnings do, mostly. Why then is PE the most popular valuation metric used globally? First, it is easy to compute – all you need is the current share price and either trailing or forward earnings for one year and it is simple enough for most people to understand. Whatever said and done, it does form a reasonable starting point for valuation.