Markets and Valuations Differences
by, Steve Taddie CBE® CFM
Director, Senior Portfolio Manager
Market pundits often refer to the term a “market of stocks” to refine a conversation about the “stock market.” Part of that dialogue centers around the valuation of different types of company stocks, such as large, mid and small capitalization stocks, and those in specific countries, sectors, and industries. Common stocks of companies trade at a wide range of valuation levels (a/k/a PE ratios), which feeds the narrative about certain securities being cheap or expensive relative to the “market.” It becomes more complex the deeper you delve into it, as identifying the appropriate benchmark for comparison is key to producing more relevant actionable ideas. While there may be a host of reasons for differences in the valuation of specific company stocks, let’s focus on some of the key factors that may drive deviation.
What is valuation? A stock’s valuation can be based on many different per-share metrics such as Revenue, Cash Flow, Earnings, and Growth Rates of the same. One of the more recognizable valuation metrics is Stock Price to Earnings per Share (PE ratio or multiple). This metric can be compared to the market, the company’s Sector, Industry, and often to its own historical average to create an apples-to-apples comparative view of value.
Why do some companies trade at 50 (or higher) PE ratios and others trade with PEs in the single digits? Much of this is about visibility to near- and longer-term earnings expectations. It is more common for company valuations to be based on forward rather than trailing earnings, but trailing earnings provide a solid reference point. For example, if Company A earned $20 per share over the last 4 quarters and its stock price is $100, it is trading at 5 times trailing Earnings, meaning its PE is 5. If the company is expected to earn $15 in the next 4 quarters, its PE based on forward earnings would be 6.7. If this trend continues, Company A may not be a very interesting longer-term investment. Meanwhile, if Company B earned $5 per share over the last 4 quarters and is trading at $100, it is trading at 20 times trailing earnings, meaning its PE is 20. If the company is expected to earn $10/share in the next 4 quarters, its PE based on forward earnings would be 10. If earnings continue this trend, Company B could be a very interesting longer-term investment. The expected direction and rate of change in the metric used (in this case earnings) are important in assessing the valuation ratio for the security. Methods for determining a fair price to pay for expected company performance differ from analyst to analyst, further supporting the “market of stocks” narrative.
How do analysts produce earnings expectations? Estimates are based on a confluence of factors including global and domestic economic growth rates, regulatory policy winds, industry growth rates, market share growth rates, currency impacts, etc. Each analyst will assess the impact of each factor on the company’s revenues and expenses over the coming years and develop a base case for company results. Companies operating in growing economies, within high growth industries, and growing market share garner higher valuations than companies operating in slow growth or shrinking industries. The methods used are never perfect. Even exceptionally bright securities analysts can overestimate or underestimate a company’s results. When analyst consensus estimates miss the mark relative to actual results, the price of the security typically experiences short-term volatility, with the direction and magnitude of the volatility of course determined by the direction and magnitude of the miss.
When the “market of stocks” is viewed as a “stock market,” you have a tool to understand the general position, and direction of stock valuations. However, it’s equally important to understand the companies that make up specific stock market indexes, to have a useful reference tool, as metrics derived from an index are a weighted average of its components.
At present, the PE of international and emerging market stock market indexes trade at significant discounts to the S&P 500. One significant reason is the nature of the companies that make up the S&P 500 as compared with those markets. About 35% of the S&P 500 index consists of technology companies, and 10 individual companies make up about 30% of the index. Emerging market indexes sport about 2/3 of the S&P 500’s technology weighting, and the Developed International market about 1/3.
The PE of mid and smaller companies in the US also trade at a significant valuation discount to the S&P 500. The weighting of the component securities in technology is also a significant factor, with both averaging about 1/3 of the technology allocation as compared with the S&P 500.
Market indexes are not static with regard to industry weightings as market prices ebb and flow, and companies are added and subtracted from the indexes. Over time this increases the weighting for some industries and decreases the weighting for others. For today, large technology companies are sporting high valuations which will pull the valuation metrics of any index heavy in that industry higher. Just because a company has a valuation multiple that is higher or lower than the “market” does not instantly make it expensive or cheap. You must go a bit deeper, understanding the company’s business environment, the make-up of the index used as a benchmark, and the rate of change expected in the metric used in the valuation analysis, as a starting point.
The information in this report is educational and general in nature and is not intended to be, nor should it be construed as, specific investment, tax, or legal advice. Individuals should seek advice from their wealth advisor or other tax advisors before undertaking actions in response to the matters discussed. This information is as of September 1, 2024 but may be subject to change in the future.
Investments involve risks. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include risk of loss that clients should be prepared to bear.
