Market experts say stocks are too expensive. Here's how to know if they are.

  • By Al Root,
  • Barron's
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The Covid-19 pandemic has decimated 2020 earnings estimates for many companies, but the S&P 500 (.SPX) is up by a third from its March lows. The combination of falling earnings and rising stock prices has some legendary investors sounding alarm bells over stock valuations.

Tuesday, Stanley Druckenmiller told the Economic Club of New York the risk-reward for holding stocks was the worst he’s seen in years. David Tepper said the current market is the most overvalued he’s seen since 1999.

Tepper is a former Goldman Sachs (GS) trader who founded hedge fund Appaloosa Management in the early 1990s. Druckenmiller worked along side George Soros before founding his hedge fund Duquesne Capital.

Determining whether valuation is a problem requires knowing a little bit about what Wall Street looks at when valuating stocks .

Every profession loves its acronyms. Wall Street is no different.

Acronyms can be helpful, but they can also confuse. Tesla (TSLA) CEO Elon Musk once famously banned acronyms in employee emails, pointing out that it was often simpler and shorter to spell out the associated words. He was likely right. Still, understanding industry jargon makes people insiders. It’s fun to be in the club.

PE ratio is probably the best known bit of Wall Street jargon. PE, of course, is short for price-to-earnings and compares a stock price against its per-share earnings. As an example, a PE of 10 means a company’s stock is trading at 10 times estimated earnings for a specified period.

The PE ratio of the S&P 500 has averaged 15 to 16 for decades. It is now above 20 times estimated 2020 earnings. What’s more, if earnings keep falling because of Covd-19, the market multiple could top the levels seen when the dot.com bubble burst.

That is a problem, but there is the hope that 2020 earnings are an outlier. The market looks more modestly valued against on 2021 earnings, trading for about 17 times estimated S&P 500 earnings of about $163.

Seventeen times is still a little high, historically speaking, but PE multiples are also tied to interest rates. Stock returns are linked to all other returns on a relative basis. There are limits to this idea, but falling interest rates tend to push up PE ratios. The 10 year U.S. government bond—a popular bond benchmark—yields less than 1%, down from about 2.4% a year ago.

Sometimes when earnings are in flux, like now, investors will look at the PS, or price-to-sales ratio. Top-line sales are less volatile than are earnings. It is a helpful metric when profit margins are depressed. Price to sales is also helpful for valuing highflying start-ups, such as Beyond Meat (BYND), that don’t earn a bottom-line profit.

The market is trading for about two times sales, up from 1 time sales during the financial crisis. The PS ratio is elevated versus history, too, but the same point about interest rates applies to all valuation metrics.

Valuation multiples don’t fluctuate only with interest rates. Growth rates matter and so do returns. Faster-growing stocks trade at higher PE and PS multiples. And companies with a high, or improving, return on invested capital also get higher valuation multiples.

The level and change in return on invested capital, such as shareholders equity, is a sign of the health of a business and what kinds of earnings are coming down the road. Returns on equity are cyclical, like the economy, but have been trending higher. Whether returns can go even higher is a debate for another day.

Another fallout from the pandemic is higher debt. Dow Jones Industrial Average (.DJI) component Boeing (BA), for instance, just borrowed $25 billion , not to build a new plant, but to get it and its suppliers through the coronavirus air-travel slump.

Sometimes, when looking at highly leveraged companies, investors will look at enterprise value, or EV, which is essentially market capitalization plus net debt, compared with Ebitda, short for earnings before interest, taxes, depreciation and amortization. Ebitda is a great bit of Wall Street Jargon.

Ebitda is a proxy on cash flow. It is the amount of money companies have available to buy equipment as well as pay interest on their debt and, of course, dividends.

Cash, as they say, is king and cash flow is what matters in the end when valuing stocks. In fact, all valuation metrics are just proxies—or short cuts—to help figure out how much cash an investment will bring in.

“You just discount the cash flows,” a private-wealth executive in Canada said when asked how to value assets. “That’s what anything is worth.” His point is a good one. Any asset is worth the cash received from it, discounted back at an acceptable rate of return.

If only it were that simple. Forecasting cash flows and discount rates isn’t easy either. And PE, PS and EV/Ebitda aren’t the only valuation metrics available to investors. Still, knowing this amount of jargon is enough to get them in the club.

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