The always excellent Danielle DiMartino Booth comments on equities valuation, ending her article with what she considers a definitive closing argument:
[The Lindsey Group’s Peter] Boockvar suggests that investors who prefer to sleep at night gauge valuation through a clearer prism: “Instead of pricing equities off this fragile state of earnings, look at valuations compared to revenue, which cannot be manipulated. This should give a better metric of how overvalued the equity market currently is.”
What’s not to like about dividing a company’s market capitalization by its sales over the last twelve months? Hard to manipulate that. Sequestering the stocks in the S&P 500 reveals that at a median of 2.3-times sales, companies are more overvalued than ever. In the event you’d like a bit of historic context, the two-level was never breached in 1999 or 2007.
There is no denying that stocks are selling at a historically high price-to-sales ratio as many pundits are happy to flash this Ned Davis chart:
In fact, bears are much more prone to showing this other NDR chart which uses the median P/S ratio of the S&P 500 Index””:
But the other fact, generally overlooked, is that sales are currently appreciably more profitable than ever. There is common financial sense in paying more for each dollar of sales if said sales are generating more profits. Current net operating profit margins on the S&P 500 Index are 10% higher than in 2007 and 30% higher than in 2000. (Chart from Ed Yardeni)
It is essential to always consider trends in profit margins when assessing equities based on the price/sales ratio. Rising margins are not exclusive to the largest S&P 500 companies as these two Morningstar/CPMS charts illustrate. (Average (black) and median (red) P/S and net margins on the 2178 companies comprising the CPMS database)
One might say that we are back to the problem we were initially trying to dismiss, that profits are manipulated in so many ways that P/E ratios have become meaningless. But using the more straightforward, less manipulated cashflow margins provides even more support to the increased value of American companies sales:
This is truly remarkable, isn’t it? Current average cashflow margins are 18% of sales, up 28% from 14% in 2008 and up 50% from 12% in 2000. The median cashflow margin rose somewhat less but is nonetheless more than 30% higher than it was in 2000. Pretty tempting to pay up for these sales, isn’t it?
Warnings of an imminent mean reversion in profit margins have been recurrent since 2010 but other than the recent drop in energy company margins, there is scant evidence of this happening on a grander scale just yet. In fact, both operating (“pro forma” in RBC Capital’s chart) and GAAP earnings ex-Energy have continued to rise in the last 18 months.
I will eventually expand on why margins have been rising so much for so long. Some of the macro reasons have been mentioned in these previous articles:
Of greater interest here are the dynamics within the U.S. economy and the equity markets and their respective impact on aggregate profit margins and the P/S ratio.
The ever rising importance of Information Technology in our lives and, as a consequence, in the U.S. industrial fabric and the equity market is the main factor in the upward trend in aggregate profit margins.
IT companies net profit margins have increased from 6% in 1995 to their current 16.6%. Meanwhile, the weight of IT companies in the S&P 500 Index has swelled from 7% to 20.4%. This combination of rising margins with a huge 13% increase in IT’s relative index weight has boosted aggregate S&P 500 margins by nearly 3.0% in 20 years, accounting for most of the 3.9% increase in aggregate S&P 500 margins since 1995. (Left chart below from Ed Yardeni with the blue line = S&P 500; right chart is IT’s weight in the S&P 500 Index from Bespoke Investment).
Other sectors which have shown a significant and sustained rise in profit margins are Consumer Discretionary and Industrials. The weight of CD companies has been very volatile over the years but it is now at the same 13% it was back in 1995. Industrials, however, have seen their weight decline from 13% to 10% over the last 20 years although it has been fairly stable since 2002.
IT companies are currently selling at 3.4x sales compared with 1.8x for the S&P 500 Index. Given IT’s 21.4% weight in the Index, it is contributing 0.7 points to the aggregate 1.8x P/S ratio for the Composite. Ex-IT, the S&P 500 P/S ratio is 1.1x.
Back in 1995, IT’s P/S ratio was 2.5x which, given its 7.0% weight, contributed 0.2 points to the S&P’s then 1.1x P/S ratio. Ex-IT, the P/S ratio was thus 0.9x back in 1995, only slightly below its current reading. Since ex-IT margins have grown 90 basis points during the period, the notion that equities are expensive on their price-to-sales ratio is not supported by facts.
HOW ABOUT PRICE-TO-BOOK?
Price-to-book is also often used to show how overvalued equities currently are. On its own, if we exclude the internet bubble era, it certainly displays peak characteristics as the Morningstar/CPMS chart shows.
But P/B is another indicator that needs to be twinned with its return component in order to have any fundamental meaning. Between 1980 and 2000, P/B embarked on a long term ascent which was supported by a secularly rising trend in ROEs. The low ROE point during the 2001-02 recession was higher than that in the 3 preceding cycles and ROEs returned to their previous peak in 2007 but without a similar jump in P/B as the market refused to pay up for companies that had become overleveraged (yellow line = debt/equity).
The uptick in ROEs in 2015 has been boosted by rising debt which is now amplifying the downtrend. So far, we can probably assert that 3x book is about the maximum that investors are willing to pay in the current environment.
In truth, it is difficult to expect that ROEs will remain in the 15% range as my June 2016 in-depth analysis concluded (CETERIS NON PARIBUS).