Paying Twice

Back in September 2007, just before the deepest market collapse since the Great Depression, I observed:

“A ‘modestly elevated’ P/E on record earnings at record profit margins is an exorbitant multiple on normalized earnings. Investors will learn this over the complete cycle.”

Likewise, early in the 2000-2002 market decline, which would take the S&P 500 down by half, and the tech-heavy Nasdaq 100 down by 83%, I wrote: “price/earnings ratios should not be considered as reliable benchmarks of value here. Over the past decade, many historically reliable benchmarks such as price/revenue, price/book and price/dividend have been discarded as antiquated. Rising profit margins drove earnings out of line with these other fundamentals, and enthusiasm about soaring earnings drove stock prices to fantastically high price/earnings ratios. We are now on the reverse side of this spike.”

With regard to the S&P 500 forward operating P/E multiple (based on Wall Street’s estimates of next year’s earnings, excluding expenses labeled as “non-recurring”), I noted near the 2007 peak:

“A forward P/E multiple on depressed profit margin assumptions provides at least some margin for error. The same forward P/E based on assumptions of the highest profit margins in history contains no such margin.”

Investors are going to learn all of these lessons yet again. When investors pay high P/E multiples on earnings that already reflect cyclically-elevated profit margins, they pay twice for their investment.

Stocks are not a claim on next year’s earnings. They are a claim on a very, very, long-term stream of cash flows that will be delivered into the hands of investors in the future. Whatever "fundamental" one uses in a valuation ratio had better be a reliable “sufficient statistic” for expected cash flows that investors will receive decades from now.

At a 4% dividend yield and smooth growth in fundamentals over time, nearly 50% of the present value of an investment represents cash flows that will be received more than two decades in the future. At a 2% dividend yield (which is the current dividend yield on the S&P 500), nearly 70% of the present value comes from cash flows that are expected to be received more than 20 years out.

The fact is that across history, revenues have been a dramatically better “sufficient statistic” for market-wide cash flows than earnings at any given time. Using a century of data on market cycles across history, it’s rather easy to demonstrate that valuation multiples should be adjusted for the position of profit margins at each point in time. In fact, one can go further and say that valuation multiples based on any arbitrary fundamental “F” should best be adjusted for the position of “F” relative to revenues.