Despite a bout of market weakness earlier this year, US equity valuations have remained at historically elevated levels throughout. Such valuations present a significant risk for long-term investors.
In the chart below, we plot the current valuation landscape using five distinct measures: the price-to-earnings, price-to- sales, price-to-book and price-to-cash flow ratios, and also the cyclically adjusted price-to-earnings ratio (CAPE). The first four ratios use consensus analyst forecasts over the next twelve months as the denominator. The CAPE ratio, on the other hand, assesses the current price of the US stock market relative to the average of annual inflation-adjusted earnings over the past decade to smooth out fluctuations in the business cycle. As each valuation ratio has its strengths and weaknesses, we find this combined approach provides a more comprehensive view of the market.
To aid comparison, each measure is compared to its historic range over the past 20 years. A reading of 50% would mean the ratio is in line with its average over this period, while a reading of 99% would imply that, on this measure, US equities have historically only been more expensive 1% of the time.
Firstly, it is striking that all measures are currently at, or close to, record high levels (the blue diamonds on the chart). Secondly, even at the depths of April’s tariff-induced turmoil – at which point US equity indices were down some 20% from their peaks – valuations remained extremely elevated (the grey diamonds). Thirdly, we would argue that these ratios are flattered by aggressive consensus analyst estimates. For example, earnings growth over the next twelve months is forecast to be c12%, close to one-and-a-half times the long-term historic average growth rate. Substituting in less ambitious forecasts would leave the market looking even more expensive.
Historically, valuations have provided a strong signal for long- term investors. When the market has been this expensive, future returns have invariably disappointed. Unfortunately, it is also true that valuations offer little insight into short-term returns, and valuation-aware investors must be willing to endure the prospect that the market continues to rise for some time, getting more expensive still. This, however, is not sustainable. While some may argue that “this time is different” because of the historically strong profitability of technology companies that have come to dominate the index, we would counter that high current valuations inescapably reduce the future returns investors can expect from even the strongest of companies – at some point even the most optimistic investor must recognise that prospective returns are more attractive elsewhere.
We would suggest that April’s sell-off shows the risk inherent in the market’s current extreme valuations. If even a 20% decline scarcely moved the dial, what will it take for US equities to return to more reasonable valuations?
Glossary
Price-to-Earnings Ratio: This measures the price of a stock as a multiple of its annual profits. Price-to-Sales Ratio: This measures the price of a stock as a multiple of its annual revenue.
Price-to-Book Ratio: This measures the price of a stock as a multiple of its book value – defined as a company’s assets minus its liabilities – providing a view of its valuation relative to its tangible net-worth.
Price-to-Cash Flow Ratio: This measures the price of a stock as a multiple of its operating cash flow, which is the net-cash generated from a company’s core business activities.
Consensus Analyst Forecast: An average of sell-side analyst expectations for company fundamentals over the next 12-months. These are aggregated to provide a forecast at the stock market level.
