U.S. equity valuation and implied returns

Brandon Snow's picture

Here is a quick discussion on multiples from our Strategist, Bob Swanson.

Recently, some attention has been placed on market valuation. Here we attempt to relate valuation to subsequent equity performance. The most common measure of valuation is the price to earnings ratio (P/E). Cambridge evaluates both the historical and projected P/E ratios. Today’s P/E ratio, based on the prior 12 months, is 17.9x while the 12-month forward P/E is 16.5x. Both of these measures are slightly above historical averages as seen in the chart below.

Chart 1: Historical P/E with Average

Source: Factset

Of more interest is the subsequent return one can expect from various valuation levels. In the chart below, we compare various starting points for historical P/E and the subsequent 1, 3, 5, and 10-year returns. The long run average P/E is approximately 16x, while the long run average stock return is approximately 10%. Returns are inversely related to starting valuation points, as seen in the following chart. Intuitively, buying stocks with lower than average P/E’s should result in achieving higher than average returns. At today’s valuation level of just under 18x, the implied return over the next 3-5 years is in the mid-single digits.

Chart 2: P/E tranches

Source: Bloomberg, Globe Hysales

Longer term measures

There has been a lot of discussion lately regarding Cyclically Adjusted Price Earnings (CAPE), otherwise known as the Shiller P/E. This measures the price to the 10 year average of inflation-adjusted earnings. The argument for CAPE is that this measure normalizes the cyclical troughs and peaks of the business cycle. At current levels, the Shiller P/E is 25x, which is well above the historical average of 16.5x. Expectations for future returns are based on the current P/E mean reverting to historical averages, which from today’s levels suggest a return of just 1% per year for the next decade.

Another long term valuation measure earnings is Tobin Q ratio, created by James Tobin. This measure focuses on asset values rather than earnings. This ratio compares a company’s market value to the replacement cost of a company’s assets. The output from this calculation also suggests the market is trading well above historical averages, but still well off the 1999 peak.

The message from each of these longer term measures is that the market is expensive, and that future return expectations should be more muted.

Key takeaways

None of these measures can predict the future, but they should serve as a guide. We should not expect the 20+% annualized returns that we have enjoyed the last five years to continue. Market valuations have re-adjusted and are now much higher than they were five years ago. Based on current valuation levels, the implied return would be slightly below historical averages of 10% while longer term measures suggest returns in the low- to mid-single digits.

Implications: From a portfolio perspective, Cambridge has been disciplined in our approach toward valuation, and agrees that many issues are trading at a premium. As a result, we too have been carrying higher levels of cash than normal.

From an investors’ perspective, expectations need to be aligned with historical precedent. We believe that our funds with more modest expectations should provide the most attractive risk adjusted returns. In the Cambridge fund line-up, we would highlight the Canadian Asset Allocation Fund and the Canadian, U.S., and Global Dividend Funds as choices that have the potential to generate attractive absolute returns with lower levels of volatility.

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