Tuesday, May 29, 2007

Valuation Analysis: Why Multiples May Not Expand

Since September of last year, I have posted numerous comments re why stocks are and will remain undervalued. The central point of my argument deals with risk. The valuation tools used are forward looking and are best and simply viewed in a modified Fed Model (see May 23 posting below). There is another aspect of valuation, however, that bears noting (or is it what the bears are noting?): Is the current and expected level of various valuation metrics above, at, or below their respective long term averages? To shed some light on the subject, an interesting piece of valuation work has been produced by sector expert, Merrill's Brian Belski.

From an historical perspective (which is not always the best way to make valuation decisions), an argument can be made that stocks are not undervalued. Using the average of the past 16 years as the centerpoint, the two above charts (Brian Belski, Merrill Lynch, May 9, 2007) paint a picture of a market that is already more than fairly valued.

The first chart makes it clear that on a P/E basis, stocks are just slightly undervalued. However, on a Price to Cash Flow basis (second chart), stocks are actually quite overvalued.

Investment Strategy Implications

Using such historical data neglects other important valuation inputs, most notable of which is interest rates*. Nevertheless, the past can be a useful guide, particularly as an indicator of cycle ranges. In the current cycle, a US market that trades at or below fair value is appropriate.

While more than a handful of investment strategists believe multiples can and should expand, I beg to differ. Considering risk in all its forms (geo political, liquidity induced bubbles, over extended US consumer, untested decoupling, profits deceleration, high global growth dependence on immature emerging countries, etc.), the above noted historical data for the current market cycle suggests multiples may not expand.

*The charts also invite other questions and further analysis, such as: for the current market cycle, why has the price to cash flow levels consistently been above their long term average?

Note: Conclusions reached on this blog entry are solely those of Vinny Catalano and should not be construed as being those of Mr. Belski or Merrill Lynch. Additionally, Belski employs different methods for determining the long term average for each indicator. For a further description of the methodologies used, please see the Belski report "Sector Valuations - May 2007"

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