An Interesting Situation

Financial professionals rely on long-term historical averages when making capital market assumptions and not all starting points are the same. Investors should take current stock valuations into account as they make financial plans and allocate assets.

Getting into the market when stocks are highly valued can work against an investor. Even over time horizons as long as 20 years or more investing in high valuation environments can lead to below average returns. Conversely if stock valuations are low when the investor begins, this can lead to above average returns over an economic cycle. 

Even young investors with long time horizons should be mindful not to assume too much risk in an overvalued market even if the long-term return eventually averages out to what was initially anticipated. 

Lets take a look at an interesting situation between historical growth rates and a well-known valuation metric used by financial professionals called the P/E ratio.

The ubiquitous P/E ratio, which is defined as the (Price per share) / (Earnings per share). The P/E ratio has units of years, which can be interpreted as the number of years of earnings to pay back purchase price.

P/E ratio is often referred to as the "multiple" because it demonstrates how much an investor is willing to pay for one dollar of earnings. 

Right now, large well-known Technology companies are being priced at valuations below their historical 3-year average (chart below). 

Now let's compare this with four companies below which are classified as "Consumer Staple" companies. These are companies that sell essential products used by consumers. These are typically goods that people are unable or unwilling to cut out of their budgets regardless of their financial situation. This makes these companies non-cyclical in nature. 

Below is a Scatter Plot of both the Technology and Consumer Staple companies from above. This graph is comparing their current valuation (P/E on the x-axis) vs. 3-year Earnings per Share Growth (Y-axis). As is apparent, the Technology companies have had substantially higher earnings per share growth (Y-axis) while their current valuations (X-axis) is lower. 

On the Scatter Plot, the upper left corner would be the best quadrant and the lower right would be the worst quadrant. ​

So what are these numbers and charts saying?

These 3 charts are conveying the following:

1. Large Technology companies are priced lower than their historical 3-year average (1st chart). 
2. Consumer Staples companies are valued at or above their 3-year historical average (2nd chart). 
3. Technology companies are less expensive than the Consumer Staple companies (3rd chart). 
4. Technology company's earnings are growing substantially faster than the Consumer Staples companies (3rd chart). 

What does all this mean?

Collectively the four Technology companies look inexpensive relative to the four "so called" safer Consumer Staple companies. Keep in mind this doesn't mean that these Technology companies can't go lower. 

All else being equal, it's better to own a company or a collection of companies with higher earnings growth and a lower valuation. ​


-Paul R. Rossi, CFA

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