U.S. Equities: Valuation & Fundamentals: LM Market Insight

LM Market Insight:
U.S. EQUITIES: VALUATION & FUNDAMENTALS
DEC 2015
THIS MATERIAL IS ONLY FOR DISTRIBUTION IN THOSE COUNTRIES AND TO THOSE RECIPIENTS LISTED. PLEASE REFER TO THE
DISCLOSURE INFORMATION ON THE FINAL PAGE.
IN THE UNITED STATES - INVESTMENT PRODUCTS: NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE
For Internal Use Only
Are current equity valuations stretched?
S&P 500 valuation measures
Sources: Bloomberg, S&P Dow Jones Indices and S&P Shiller Market Data, as of 11/30/15. Nov 2015 P/E is based on 4Q15 earning estimates and index price
as of 11/30/15. The forward P/E is based on quarterly S&P earnings estimates through December 2016. This information cannot be guaranteed and all liability is
disclaimed on S&P’s own behalf and on behalf of its information providers for any damages or losses arising from any use of this information. Past performance
is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This
information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
* The Price/Earnings average is based on the quarterly operating P/E since December 1988; all others are 20-year averages.
All investments involve risk, including loss of principal. Page 2

Please see pages 10-12 for important disclosures and definitions of terms
INVESTMENT PRODUCTS: NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE
S&P 500 is no longer cheap on a P/E basis
S&P 500 P/E ratio: trailing 12 months and forward basis S&P 500 Cyclically-Adjusted Price Earnings (CAPE) Ratio
50
35 45
40
30
35
Price‐to‐Earnings Ratio
25
30
20 25
20
15
15
10
10
5 5
0
0
Dec-56
Dec-77
Dec-98
Jun-67
Sep-72
Jun-88
Sep-93
Jun-09
Sep-14
Mar-62
Mar-83
Mar-04
Dec‐88
Dec‐92
Dec‐96
Dec‐00
Dec‐04
Dec‐08
Dec‐12
Dec‐16
Recession P/E Forward P/E Avg since 12/88 Recession CAPE AVG
•The S&P 500 P/E ended November 2015 at 20x – above its average of •The CAPE ratio ended August 2015 at 26.3x – vs. a long-term average of
18.7x since December 1988. 19.6x.1
•2016 forward P/E was16.5x as of 11/30/15, based on estimated earnings • Note: some argue this measure now overstates valuation because of
for calendar year 2016. accounting changes that may have introduced significant distortions into the
calculation.
Sources: S&P Dow Jones Indices and S&P Shiller Market Data, as of 11/30/15. Aug 2015 P/E is based on 4Q15 earning estimates and index price as of 11/30/15. The forward P/E is
based on quarterly S&P earnings estimates through December 2016. This information cannot be guaranteed and all liability is disclaimed on S&P’s own behalf and on behalf of its
information providers for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Indexes are unmanaged, and not available
for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual
investment.

Other popular valuation measures tell a similar story
S&P 500: Price-to-Book & Price-to-Sales S&P 500: Price-to-Cash Flow & EV-to-EBITDA
6
20
5 18
16
4 14
12
3
10
8
2
6
4
1
2
0 0
Dec‐95
Dec‐97
Dec‐99
Dec‐01
Dec‐03
Dec‐05
Dec‐07
Dec‐09
Dec‐11
Dec‐13
Dec‐95
Dec‐97
Dec‐99
Dec‐01
Dec‐03
Dec‐05
Dec‐07
Dec‐09
Dec‐11
Dec‐13
P/B Ratio P/S Ratio Avg P/B Avg P/S P/CF Ratio EV/EBITDA Avg P/CF Avg EV/EBITDA
At the end of Nov 2015: At the end of November 2015

• Price-to-book was 2.8x, below its 20-year average of 3.0x. • Based on Enterprise Value - to - EBITDA, the S&P 500 traded
• Price-to-sales was1.8x, above its 20-year average of 1.5x. at 12.7x, above its 20-year average of 11.0x.
• Price-to-cash flow was 10.9x, below its 20-year average of 11.6x.
Source: Bloomberg, as of 11/30/15. See page 9 for index definition. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index
returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Please see pages 10 – 12 for important disclosures and definitions of terms
From an income standpoint, stocks compare favorably
with Treasuries
S&P 500 dividend per share and payout ratio S&P 500 earnings and dividend yield; 10yr UST yield
$45 80% 10%
$40 70%
8%
$35
60%
Dividend payout ratio
$30
Dividend per share
50%
Yield (%)
6%
$25
40%
$20 4%
30%
$15
20% 2%
$10
$5 10%
0%
$0 0%
Dec-95
Dec-99
Dec-03
Dec-07
Dec-11
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
2014
S&P 500 Dividends (left axis) S&P 500 Dividend Payout Ratio (right axis) Recession S&P 500 Earnings Yield 10yr UST Yield S&P 500 Dividend Yield
Dividends have experienced solid growth Stock yields compare favorably to UST yields
As of November 30:
.Record high dividend per share, but at 40% the payout ratio is below its
historical average of 48% since 1950 • S&P 500 earnings yield = 5.4%
Record corporate cash suggests potential for continued dividend growth • S&P 500 dividend yield = 2.1%
• 10yr UST yield = 2.21%
Sources: S&P Dow Jones Indices, S&P Shiller Market Data and Bloomberg. Dividend per share data , S&P 500 earnings yield data, S&P 500 dividend yield data and 10-year UST yield
data as of 11/30/15. Dividend payout ratio as of 9/30/15. This information cannot be guaranteed and all liability is disclaimed on S&P’s own behalf and on behalf of its information providers
for any damages or losses arising from any use of this information. See page 9 for index definition. Past performance is no guarantee of future results. Indexes are unmanaged, and not
available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an
actual investment.

Fundamentals could provide support for prices
S&P 500 Operating Earnings, actual and estimated S&P 500 profit margin
$140 12
$120 10
Trailing 12‐month profit margin
$100
8
$80
Earnings
6
$60
4
$40
$20 2
$0 0
Dec‐88
Dec‐92
Dec‐96
Dec‐00
Dec‐04
Dec‐08
Dec‐12
Dec‐16
Sep‐95
Sep‐97
Sep‐99
Sep‐01
Sep‐03
Sep‐05
Sep‐07
Sep‐09
Sep‐11
Sep‐13
Sep‐15
Recession S&P Annual Earnings Estimated Recession Profit Margin Average
After a record recovery from the last recession, earnings growth has stalled; rebound seen in 2016
•As of 11/30/2015, S&P 500 earnings growth for the 12-months ended 12/31/15 is estimated to be down -5.6% from a year earlier compared with a gain
of 5.3% in December 2014.
•As of 11/30/2015, S&P 500 earnings are expected to grow 18.6% to $126.5 at the end of 2016
.
S&P 500 profit margin is down from recent peak, but still high
•Profit margin was 8.3% as of 11/30/15, down from a high of 9.6% in September 2014.
Sources: S&P Dow Jones Indices and Bloomberg, as of 11/30/15. This information cannot be guaranteed and all liability is disclaimed on S&P’s own behalf and on behalf of its information
providers for any damages or losses arising from any use of this information. See page 9 for index definition. Past performance is no guarantee of future results. Indexes are
unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the
performance of an actual investment.
Please see pages 10 - 12 for important disclosures and definitions of terms
Sales growth has been slow, but debt is down and free
cash flow is up since the financial crisis
S&P 500: revenue per basic share S&P 500: total debt and free cash flow
$1,400 $1,400 $140
$1,200 $1,200 $120
Free cash flow per share

$1,000
Total debt, billions

$1,000 $100
$800 $800 $80
$600 $600 $60
$400 $400 $40
$200 $200 $20
$0
$0 $0
Dec‐95
Dec‐99
Dec‐03
Dec‐07
Dec‐11
Sep-95
Sep-99
Sep-03
Sep-07
Sep-11
Sep-15
Recession Revenue per share Linear (Revenue per share)
Recession Total Debt Free Cash Flow Per Share
• Sales were slower to rebound than corporate profits and earnings

• Total debt remains well below pre-recession levels
. following the recession and have recently stalled
• Sales growth could accelerate if the recovery broadens, particularly • Free cash flow is well above pre-recession levels
given pockets of pent-up demand.
Source: Bloomberg, as of 11/30/15. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees,
expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Economy-wide, after-tax corporate profits and corporate
cash are near record high levels
US After-tax corporate profits US corporate cash
$2,000 $2,500
$1,600 $2,000
$1,200 $1,500
Billions
Billions
$800 $1,000
$500
$400
$0
$0
Sep-95
Sep-99
Sep-03
Sep-07
Sep-11
Sep-15
Sep-95
Sep-99
Sep-03
Sep-07
Sep-11
Sep-15
Source: Bloomberg, as of 9/30/15. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of
an actual investment. Corporate profits are represented by domestic non-farm non-financial corporate business liquid assets.

Fundamentals matter more as valuations rise
• Investors appear cautious about

higher valuations Domestic equity funds: 12 month cumulative net new cash flow
• Outflows from long-term $50
domestic equity funds may reflect

elevated skepticism
$0
•That’s unusual for market tops,
which have generally been
‐$50
associated with investor
Billions
exuberance
• While a fairly valued market ‐$100
implies fewer outright bargains, it

does not mean there are no
‐$150
attractive opportunities in today’s
market
• That underscores the potential ‐$200
Nov‐08
Nov‐09
Nov‐10
Nov‐11
Nov‐12
Nov‐13
Nov‐14
Nov‐15
value of active stock pickers who
focus on the fundamental
strengths and weaknesses that
differentiate individual firms
Source: Investment Company Institute, as of 12/16/15. Nov 2015 flows are estimated as of week ended 12/9/15. Past performance is no guarantee of future results. This information
is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Investment risks:
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance,
or a guarantee of future results, or investment advice.
Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.
Common stocks generally provide an opportunity for more capital appreciation than fixed-income investments but are subject to greater market
fluctuations. Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more
established companies.
Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make
interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could
increase volatility. These risks are magnified in emerging markets.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government
guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities,
debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and
credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does
not apply to losses resulting from declines in the market value of these securities.
Active Management does not ensure gains or protect against market declines.
Yields and dividends represent past performance and there is no guarantee they will continue to be paid.
All investments involve risk, including loss of principal.

INVESTMENT PRODUCTS: NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE Page 10
Definitions of terms:
•The cyclically adjusted price-to-earnings ratio (CAPE) is defined as price divided by the average of ten years of earnings, adjusted for
inflation.
•Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price.
•The earnings yield is the earnings per share for the most recent 12-month period divided by the current market price per share. It is the inverse
of the P/E ratio.
•EV / EBITDA equals a company's enterprise value divided by earnings before interest, tax, depreciation, and amortization. It measures the price
(in the form of enterprise value) an investor pays for the benefit of the company's cash flow (in the form of EBITDA).
•The forward P/E ratio is a stock’s (or index’s) current price divided by its estimated earnings per share (or estimated index earnings), usually one-
year ahead.
•Free cash flow (FCF) is measure of financial performance calculated as operating cash flow minus capital expenditures. It represents the cash
that a company is able to generate after laying out the money required to maintain or expand its asset base. FCF is important because it allows a
company to pursue opportunities that enhance shareholder value.
•Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a
country in a given period of time.
•Operating earnings is profit earned after subtracting from revenues those expenses that are directly associated with operating the business,
such as cost of goods sold, administration and marketing, depreciation and other general operating costs.
•The price-to-book (P/B) ratio is a stock's price divided by the stock’s per share book value.
•The price-to-cash flow (P/CF) ratio is a stock's price divided by the amount of cash generated per share by a company's operations.
•The price-to-earnings (P/E) ratio is a stock's price divided by its earnings per share.
•The price-to-sales (P/S) ratio is a stock's price divided by its sales per share.
•The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. An
investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Important Information
All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates,
general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital.
Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates
rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements
made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially
from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions
expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or
needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any
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U.S. EQUITIES: VALUATION & FUNDAMENTALS

All investments involve risk, including loss of principal. Page 2

All investments involve risk, including loss of principal. Page 3

P/B Ratio P/S Ratio Avg P/B Avg P/S P/CF Ratio EV/EBITDA Avg P/CF Avg EV/EBITDA

At the end of Nov 2015: At the end of November 2015

All investments involve risk, including loss of principal. Page 4

All investments involve risk, including loss of principal. Page 5

$1,200 $1,200 $120

Free cash flow per share

Total debt, billions

$800 $800 $80

$600 $600 $60

$400 $400 $40

$200 $200 $20

• Sales were slower to rebound than corporate profits and earnings

All investments involve risk, including loss of principal. Page 7

All investments involve risk, including loss of principal. Page 8

• Investors appear cautious about

domestic equity funds may reflect

implies fewer outright bargains, it

All investments involve risk, including loss of principal. Page 9

All investments involve risk, including loss of principal.

All investments involve risk, including loss of principal.

All investments involve risk, including possible loss of principal.

All investments involve risk, including loss of principal.

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