U.S. STOCKS HAVE BEEN at nosebleed valuations for much of the past three decades—or so say the yardsticks used to measure stock market value. But what if the problem isn’t the lofty price of stocks, but rather the yardsticks we’re comparing them against?
When we try to gauge whether shares are pricey or cheap, we typically look at the dividends that companies pay, the profits they generate and the assets they own. Yet these three crucial numbers have all undergone fundamental changes in recent decades—and the result is that stocks appear more expensive than they should.
Don’t get me wrong: I’m not claiming U.S. shares are cheap. Far from it. But I’ve come to believe the U.S. market is less overpriced than it seems. Consider:
Dividends. When declaring whether the stock market is over- or undervalued, experts no longer pay much attention to the market’s overall dividend yield, currently 1.9% for the S&P 500. Yes, that’s well below the 2.9% average for the past 50 years.
Problem is, many companies are downplaying dividends and instead using spare corporate cash to buy back stock. I have mixed feelings about this, in part because buybacks seem like a sneaky way to cover up the impact of employee stock options, which effectively take a slice of the company from outside shareholders and gives it to management.
Still, there’s no doubt that buying back shares is more tax-efficient than issuing dividend checks. Those dividend checks mean an immediate tax bill for all taxable shareholders, while a buyback program only generates a tax bill for those shareholders who choose to sell.
What if you combine the S&P 500’s 1.9% dividend yield with the so-called buyback yield—the percentage of their own shares that the S&P 500 companies are repurchasing each year? The total annual cash return to shareholders appears to be more than 5%.
Earnings. Under generally accepted accounting principles, or GAAP, if a company buys a building or a piece of equipment, it’s allowed to write off that expense over the useful life of the investment. Result: The immediate hit to reported earnings can be relatively modest, plus these capital expenditures show up as an asset on the company’s balance sheet.
By contrast, under GAAP, research and development costs are expensed in the year they occur. That means there’s an immediate hit to reported corporate profits, plus the fruits of that R&D typically aren’t counted among the assets on the balance sheet. Let’s say a pharmaceutical company develops a new drug. The R&D cost would hurt earnings right away and the resulting patent usually wouldn’t appear as an asset, unless it was acquired from another business, and yet the drug might be hugely valuable.
This impact can be especially harsh for fast-growing companies that are spending more and more on R&D each year. That burgeoning R&D cost may be setting these corporations up for an even brighter future, and yet the hit to reported earnings may make their shares look overvalued.
This is a bigger issue than it was three decades ago. Think about today’s superstar companies, like Apple, Alphabet’s Google, Facebook and Netflix. These companies haven’t prospered by building huge factories. Instead, they’re renowned for their valuable brand names and great intellectual capital.
As such companies have come to dominate the stock market, valuations have gotten distorted: Reported earnings are lower than if these firms were spending on capital improvements—and the stock market’s overall price-earnings ratio has been driven higher. Indeed, despite the boost to earnings from the recent corporate tax cut, the S&P 500 stocks today are trading at 22.8 times trailing 12-month reported earnings, versus a 50-year average of 19.4.
Assets. Back in the mid-1980s, when I started writing about finance, investors used to pay close attention to how stock prices compared to book value. Book value is the difference between a company’s assets and its liabilities, expressed on a per-share basis. Three decades ago, if a stock was trading well below its book value, that was often taken as a sign that the shares were a bargain.
Today, book value is still used to sort the stock market into growth and value stocks—but the focus is on how stocks are priced relative to one another, based on their price-to-book value. What about using book value to assess whether the entire market or individual stocks are absolutely cheap? You don’t hear about many folks doing that.
Why not? Just as GAAP accounting penalizes spending on R&D, it also penalizes intangible assets, such as patents, copyrighted material and brand names, which typically don’t show up on a corporation’s balance sheet.
One consequence: The S&P 500 now trades at 3.6 times book value, versus less than 1.5 times in the mid-1980s. Similarly, Tobin’s Q—which compares share prices to what it would cost to buy a corporation’s assets today—has also fallen out of favor. Based on Tobin’s Q, stocks are trading at an 81% premium to replacement values, compared with a discount of some 60% in the mid-1980s.
All this is yet another example of why the financial markets are so utterly maddening. We imagine we have some concrete way to assess the stock market’s fundamental value, only to discover that the truths we hold dear are no longer true.
So what is true? As always, we should fret less about the markets and focus more on the things we can control. Those things are fivefold: risk, investment costs, taxes, our emotional reaction to market turmoil, and our savings rate if we’re still in the workforce and our spending rate if we’re retired. Diligently focusing on all five? If you are, it likely doesn’t matter whether stocks today are overvalued or not.
Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Cash Back, Crazy Like a Fox and Guessing Game. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.
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And.. we in India are wondering about the same thing..
Nice analysis Jonathan. I’ve also been pondering some “collective wisdom” tidbits that “everyone knows” but in my view don’t really stand up very well with a closer analysis. For example, I’ve been looking at the age-old conundrum of stocks vs. bonds, and how that “everyone knows” that bonds are “less risky” than stocks and only those with “an appetite for risk” should invest a higher percentage of their asset pool in stocks. Really? From my point of view, long-term rates of less than 2 percent–in some cases, *way* less–carries substantial risk, even if there’s zero default risk. Have those “experts” never heard of inflation? Given the choice between a 30-year bond at 2 percent, vs. an S&P 500 fund, that bond bet looks a heckuva lot more “risky” to me. I mean, even with a meager dividend yield of 2% or so, the stock fund has a yield more or less equal to the long bond, and has a pretty good shot of appreciating and keeping up with inflation over the long haul as well. The bond? Not a chance–in fact, if inflation runs at even historically normal levels, that bond will DEpreciate in value over time. And this is even before we talk about taxes, which will lop off another substantial chunk of that already meager bond yield, but far less (potentially zero!) of the stock yield plus its appreciation. Now remind me again, which of these is supposed to be the “risky” bet?
Your “nosebleed” analogy captures the spirit of this pretty well. After a while, our body adapts and adjusts to the altered climate conditions, and those eventually subside. I think the problem with a lot of our current financial advice is, it’s tailor made and works pretty good, but mostly for market conditions from 20 or 30 (or even 40) years ago. Maybe it’s time to re-evaluate and update some of our collective wisdom; this is one of the main reasons I find your blog so enjoyable. Thank you.
I remember the myriad of articles attempting to justify the skyrocketing P/E’s of the late 90’s that finally popped the dot-com bubble. We were looking for some reason not to bail as the sky darkened, and I never did, but the angle of inclination gave me nightmares about tulips.
Intellectual vs. physical capitalization was one of my favorites back then as it is now, because it’s true. I love the point you make about the buyback trend and the marvelous link you provided that overlays it with dividends. That’s why you get the big bucks! 🙂 Along with the smooth ride we’ve had over the last decade, this is as comforting as the Shanghai dilution is scary.
Meanwhile, dealing with those (5) areas under our control with a healthy time horizon wins the prize and greatly increases the entertainment value of the financial news.