Valuation: All in the Eye of the Beholder

excerpts from this week's report

Astute investors know that equity valuation is 2 parts science, 1 part art. The methodology used to derive the science part of the valuation equation is fairly well known – cash flows (or earnings, if you prefer), a projected growth rate, and a discount rate. The fabled discounted cash flow (DCF) model.

However, valuation isn’t all science. Numerous behavioral finance studies have made this quite clear and irrefutable. Loss aversion is as much a part of the valuation process as risk aversion is. And the regret factor plays a very large role in the investment decision-making process.

As equities move into new high territory, the fundamental anchor is valuation. It is the justifier for M&A, as well as the analytical support for equity positions taken and held. As long as there is a projected higher valuation level forecasted (based upon the mix of the three DCF inputs), investors are able to find reasons to remain long. Which brings us to a very reliable and effective valuation tool for the overall market – the Fed Model.

As shown on the following page (see report), the updated Fed Model shows a valuation gap still remains despite the current double-digit rally. The only question is just how wide is that gap?

As the model makes clear, if one uses the current 10-year Treasury as the discount factor, then stocks have a very long way to go to the upside. However, throughout this bull market, a risk premium has always been a part of the valuation equation, which has ranged from 80 to 100 basis points. (see table in report)

Using that discount benchmark, the valuation gap is right around the rate of return an investor can get in a US Treasury. (see table in report)

The risk adjustment I have used to reflect the numerous uncertainties investors face (from exogenous events to geo political risks to financial contagion) is made via the 10-year interest rate level. By adjusting upward the discount factor* to the level it has maintained for the past several years (80 to 100 basis points), the valuation gap has closed significantly. The only question now is has the relationship between risk and reward changed?

Investment Strategy Implications

If earnings growth remains on track and rates remain well behaved, then valuation support for the equity markets will remain intact. The only issue is the aforementioned risk/reward dynamic. If that has changed, then the valuation gap is sufficiently large enough to push equities meaningfully higher.

The concern expressed here, however, is that so much has work to work so well and little can go wrong. In other words, there is little margin for error.

Valuation, like beauty, is all in the eye of the beholder. Or as Lord Keynes once said:

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”


In my opinion, it won’t take much to change perceptions.

*In the Fed Model case, the 10-year Treasury is used as a capitalizaton rate. Nevertheless, the effect is the same as a discount rate used in a DCF model.

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