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MARKET
INSIGHTS
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www.investopedia.com
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The fundamentals
There are several different ways to determine the fundamental value of a stock or group of
stocks (a market). When looking at an individual security, a combination of forward and trailing
multiples, along with more academic approaches to valuation (such as a discounted cash flow
[DCF] analysis) are common. Creating an effective DCF for one company requires at least five
to 10 years of reliable projections and assumptions for growth and the cost of capital, with
the caveat that the output is only as
reliable as the inputs. In other words, the CHART C: Stocks are Closely Correlated to Forward Earnings
quality of the research matters. While you Estimates in the Long Run
could certainly run this type of analysis S&P 500 total return and next 12-month EPS
for an entire index, doing this well for
500 companies (the S&P 500 Index for
S&P 500 – Total Return Index (left) S&P 500 – Earnings per Share (right)
example) requires an entire team of
experienced analysts. $3,000 $120
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MARKET
INSIGHTS
In looking at forward P/E ratios as of July 31, 2010, Wall Street expects S&P 500 operating
earnings to be $84 in 2010 and $96 in 2011. Based on the S&P 500’s closing price of 1102 (7/30),
the index was trading at 12.1x forward earnings (next 12 months of earnings). Chart D, from the
Guide to the Markets, illustrates this price/earnings ratio for the S&P 500 over the past 18 years.
Although forward P/E ratios have limited historical data, based on an 18-year average, equity
markets appear undervalued. Thus, it is worth understanding what has helped to compress the
P/E multiple. As this is being written, a stock market correction has depressed the numerator
(“P”), while earnings projections in the
CHART D: S&P 500 Index, Forward P/E Ratio denominator (“E”) continue to move
Average +/- one standard deviation higher. The dislocation in direction
between the numerator and denominator
28x of the P/E ratio highlights how short-term
price movements can deviate from the
24x fundamentals. The last time we saw a
multiple of 12.1x forward earnings in the
20x S&P 500 was in late March 2009, when
Average: 16.6x the equity markets began an epic 70%
16x rally over the following 12 months.
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Shiller’s P/E
While our preferred method of using CHART F: Price/Earnings Ratio
S&P 500, annual data, 1880-2010
forward earnings to value equities
suggests the stock market is undervalued, 50
there are other valuation methods that 45 2000
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www.econ.yale.edu/~shiller
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MARKET
INSIGHTS
The Q-ratio
In addition to trailing multiples, another valuation metric that is used is the Q-ratio4 (developed
by James Tobin), which also suggests that equities may be overvalued. This ratio, shown for
all non-financial corporations in the Guide to the Markets Chart H, measures a stock’s price
divided by the replacement cost of the company’s assets. The idea is that, over time, you should
see consistency in the price investors are willing to pay for assets. Therefore, if the long-term
average Q-ratio is 0.8, and the current Q-ratio is 1.0, investors are paying too much for assets,
and equity markets are overvalued.
The ratio is calculated by taking the market price (often by using the stock price), and dividing
it by the replacement cost of tangible assets (such as equipment, inventories, etc.) along
with financial assets. First, it should be noted that financial assets as a share of total assets
have risen dramatically over the years. In 1950, financial assets comprised 23.2% of total
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Standard and Poor’s
4
6 “Asset Markets and the Cost of Capital.” James Tobin and W.C. Brainard, 1977, Economic Progress, Private
assets, whereas they make up 53.8% of
total assets, today5. If it is the case that CHART H: Q-Ratio, Stock Price Relative to Company Assets
investors find financial assets more liquid Price to net asset value, all U.S. non-financial corporations
or attractive than physical ones, this
Less Attractive
might imply that the Q-ratio should have 2.0x
More Attractive
you looked at each of these company’s
0.5x
balance sheets, you wouldn’t actually
find a line item with the brand’s value,
and you certainly couldn’t dream up a 0.0x
replacement cost. To the extent that the ’70 ’75 ’80 ’85 ’90 ’95 ’00 ’05 ’10
value of certain intangible assets (such as Source: Federal Reserve table B.102, J.P. Morgan Asset Management.
a brand) can grow over time, the Q-ratio, Guide to the Markets, page 5
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B.102 Balance Sheet of Non-farm Non-financial Corporate Business
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MARKET
INSIGHTS
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
growth and revenue growth for the S&P
Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management.
500. Over the last 10 years, we have
observed a strong correlation between
year-over-year percent change in sales
per share for the S&P 500 and year-over-year percent change in GDP. The R-squared of 0.75
suggests that 75% of the variance in revenue growth can be explained by the variance in
economic growth. This relationship shouldn’t really surprise anyone. If you think about it, as
the economy continues to grow, the largest companies in the U.S. should benefit from that
growth in the form of increased demand. Additionally, U.S. companies function in a global
marketplace, with S&P 500 companies deriving over 40% of their revenues from business
outside the United States. Thus, even if you believe the domestic economy will grow at a very
low rate, any positive nominal GDP growth should still translate into revenue growth for S&P
500 companies, with their international business only adding additional fuel to the fire.
In addition, as companies have improved their operating margins over this past economic cycle,
each incremental dollar of sales today should translate into stronger earnings as compared
with the fourth quarter of 2008, when S&P 500 operating earnings hit an all-time low (Chart
J). Although the recovery in margins should slow as companies continue to hire, we believe
there’s still room for improvement, as we are well off the high of 2007.
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On a side note, we’ve recently heard the
argument that earnings growth must CHART J: Margins Still Have Room for Improvement
slow down; we know that companies S&P 500 operating margins, quarterly profits
are starting to hire (which is good for
S&P 500 – Operating Margin (left) Quarterly profits (right)
the overall economy) and, as a result of 20%
the increased cost, margins will begin $28
18%
to shrink and earnings growth will
16% $23
eventually go to zero. This is a little ironic.
Three quarters ago, when we were talking 14%
$18
about the opportunity in equities, the 12%
pushback we received was that “all the 10%
$13
earnings growth is coming from margin 8%
improvement from layoffs, and there’s no 6% $8
revenue growth – how can earnings keep 4%
growing?” Today, we hear the argument $3
2%
that “sure, revenue growth has come
0% ($2)
back, but it doesn’t matter because
Aug–04
Aug–06
Aug–08
Dec-03
Apr–05
Dec–05
Apr–07
Dec–07
Apr–09
Dec–09
companies are hiring and margins can
only get worse from here – how can
earnings keep growing?” Sometimes, Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management.
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MARKET
INSIGHTS
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Net income/sales (Chart L), also known
as the company’s net profit margin, CHART L: Net Profit Margin
measures bottom-line profitability: For S&P 500 net income / sales
each dollar of sales, how effective is
Net Income / Sales Average SD+1 SD-1
the company at translating sales into 10%
earnings? Sales/assets (Chart M), also 9%
8%
known as the asset turnover ratio, 7%
measures the company’s efficiency: How 6%
effective is the company in generating 5%
4%
sales given the size of its balance sheet? 3%
Assets/equity (Chart N), also known as 2%
1%
financial leverage, measures the leverage 0%
on a company’s balance sheet: Given the
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12/30/1994
12/29/1995
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12/29/2000
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12/31/2003
12/31/2004
12/30/2005
12/29/2006
12/31/2007
12/31/2008
3/31/2009
6/30/2009
9/30/2009
12/31/2009
3/31/2010
size of assets, what portion of a company
is capitalized with debt rather than
equity?
Coming out of this economic cycle, Annual LTM quarterly
we notice a clear trend in the quality Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management.
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MARKET
INSIGHTS
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Conclusion
A few general thoughts to recap our views:
• We believe that fundamentals ultimately drive the price of stocks and that long-term investors
should focus on forward earnings and profitability.
• As we look at a variety of forward valuation metrics, including price-to-earnings and price-to-
cash flow, it appears that equities are fundamentally undervalued.
• Profitability as measured by return on equity has come back to its long-term average only one
year after a very deep recession, while companies have managed to retain record amounts
of cash over the same period.
• Recent growth in profitability has been driven by improved margins and operational efficiency;
leverage has actually declined over this cycle as companies have focused on strengthening
their capital structures, resulting in quality earnings.
As we hope for the best, we encourage investors to be prepared for the worst. The biggest risks
to equity markets are those that cannot be predicted. For this reason, while we are bullish and
believe that equities are attractive, it’s important that investors maintain a balanced approach,
with exposure to equities as well as other asset classes that will help reduce volatility over the
long term.
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