Tag Archives: author

By Rupert Hargreaves Almost all fundamental investors based their research, analysis and investment decisions on the assumption that some positive relationships exist over time between equity valuation and key financial metrics. However, while a large amount of investment activity is based on the assumed relationships between the aforementioned factors, research conducted by S&P Capital IQ, shows that for the past decade it has been impossible to prove a strong statistical relationship between commonly referenced fundamental financial statistics and the direction of the equity market, momentum, and valuation: “Whether we are looking at various measures of profit margin, reported revenue and earnings growth, or even estimated future sales and earnings growth, the past decade’s correlations between price-to-earnings (P/E) valuations and a variety of commonly referenced fundamental financial statistics randomly range between strongly positive and negative readings.” – S&P Capital IQ Global Markets Intelligence Valuation versus fundamental data items Any investor that’s been watching the market for more than a year or two will know that the relationship between the valuation assigned to equities by stock market investors and underlying fundamental characteristics, over time, is extremely complex. There are many internal (stock specific) and external factors that can affect valuations. According to S&P Capital IQ ‘s research on the matter, the only net positive correlation relationship with P/E multiples since 2005 is related to selling, general, and administrative expense margins or the ratio of non-price of goods sold expenses to revenues. The best way to explain this relationship is with a table. (click to enlarge) P/E Valuation vs. Fundamental Data Items Based on a decade’s worth of data, S&P Capital’s research shows that a change in a company’s selling, general, and administrative expense margin is the only factor that will consistently impact earnings multiples across sectors. There is a clear reason for this correlation. Higher expenses will compress profit margins, weigh on profit and ultimately investors will abandon the company, driving the P/E lower. However, it’s unclear why a similar relationship doesn’t exist across other fundamental metrics. Prime example The tech sector is a prime example of an industry where the average P/E does not reflect the underlying and improving fundamentals. After the tech stock market bubble burst in 2000, the S&P 500 technology sector entered the economic recovery cycle in the first quarter of 2002 with a forward 12-month P/E valuation ratio of 54x. Between 2002 and 2010, tech sector valuations continued to be consistently marked down, although, the sector’s earnings growth averaged 23% per quarter throughout the period. The sector’s forward P/E reached a low watermark of 10.7 during Q3 2011 and has only recently started to readjust higher – as shown below. (click to enlarge) Interesting trends Aside from the obvious disconnect between P/E multiples and underlying fundamentals, S&P Capital IQ’s data highlights some other interesting trends. For example, the energy sector is currently trading at a forward P/E multiple of 33, exceeding the levels recorded while exiting the 2001 recession. The energy sector exited the 2001 recession with an elevated forward P/E of 24 that steadily declined to 8.6 by Q4 2005, well into the economic recovery and actually half way through the Fed’s tightening cycle, which took place between June 2004 and June 2006. The sector’s P/E bottomed in 2005, steadily increasing as the price of crude oil continued to rise from $50-$60 per barrel in the final quarter of 2005 to as high as $145 in July 2008. The sector P/E reached a peak of 15.3 in Q4 2008. These historic trends show that the current extreme forward energy sector P/E ratio reflects severely depressed anticipated future earnings per share relative to existing share prices, not unlike the excessive valuations seen at the tail-end of the tech stock market bubble in 2000. The excessive valuation now needs to be worked off as revenue and profit growth slowly becomes aligned with market pricing. The consumer discretionary sector illustrates more contemporary equity market valuation-related issues. Specifically, between mid-year 2004 and mid-year 2006, as the Fed continued to raise short-term interest rates at every Federal Open Market Committee meeting, investors became more cautious toward the consumer discretionary sector, pushing the sector’s P/E multiple down to 18.4 in the second quarter of 2006, from 19.4. Over the same period, sector earnings grew at an average of 8.8%: “Moving ahead to current valuations, the consumer discretionary sector’s forward P/E ratio has averaged 19.1x in the past two years while sector earnings per share growth has averaged 10.5%. Interestingly enough, this figure is close to the average P/E of 19.4x recorded by the sector during the prior period of Fed tightening when earnings grew by 8.8%. From this perspective, investors appear to be comfortable with a prospective Fed tightening cycle, as they were during most of the prior tightening cycle, as long as consumer discretionary sector earnings continue to grow at a healthy pace.” – S&P Capital IQ Global Markets Intelligence