Valuation Update

I look at several valuation metrics to ascertain whether or not the market is expensive.

Median Price/Earnings Ratio

First, the median price/earnings ratio of the stocks in the Russell 3000.  The median forward operating PE ratio of the Russell 3000 is currently 14.5x.  This is a bit higher than the long-term average.

Price to Book Value

The price to book value of the S&P 500 is currently 2.1x.  This is somewhat higher than the long-term average. 

(The long-term average includes dates before 1986.  However, my graphs start in the mid-80s.) 


Price to Sales

Price to sales is 1.2x, which is above the long-term average. 

One reason why stocks are trading higher than historical averages relative to sales is because companies are more profitable than in the past.

Over the past 25 years, the reported profit margin has averaged 5.5%.  The "operating" profit margin - i.e. excluding "non-recurring" charges Wall Street ignores, which are inconveniently reccurring - has averaged 6.5%.  Currently, the reported profit margin is 6.9% while the operating profit margin is 7.5%.

Wall Street likes to focus on "operating earnings."  Ignore this.  It is misleading and philosophically wrong.

Normalized Price/Earnings Ratio

Because profit margins are highly cyclical, I like to use normalized earnings.  Many market commentators use next year's Wall Street forecasts to value the market, which is around $86, valuing the market at less than 13x.  Margins can stay high for a while but I do not believe that margins will remain high, partly due to structural changes within China.

If we use the long-term reported profit margin of 5.5% to normalize profits, stocks are very expensive at 21.5x.

I do think that companies are more profitable than in the past but not as profitable as Wall Street believes.  I use a 7% normalized profit margin.  At 7%, the S&P500 is trading at 17x trailing normalized earnings, expensive but not egregiously so.


Growth in earnings per share over the long-run has been about 6%.  Since 1986, per share earnings growth of the S&P 500 has actually been a little lower at 5.5%. 

Per share growth of other S&P 500 metrics since 1986 are as follows;

  • Sales per share, 4.1%

  • Book value per share, 6%
  • Dividends per share, 4.2%.

Remember all those Pollyannas at the height of the Tech Bubble prognosticating about a glorious era of shy-high profit growth as far as the eye can see to justify even higher valuations? 

They were wrong.

Long-Term Forecast

I use a price/earnings and a dividend discount model to forecast expected returns over the next 20 years.  Currently, the models are forecasting compounded annual returns of 6.7% to 7.5% from US stocks, below the long-term average of 10% but above most other domestic asset classes.

It should be noted, however, that historically, long periods of over-valuation have been followed by long periods of under-valuation.  Stocks were under-valued during the Financial Crisis, terrifically so at the bottom.  However, over the past decade, stocks have not been under-valued for any prolonged period.  Is this time different, particularly after two of the greatest asset bubbles of all time?   Perhaps, but I would not bet the farm on it.

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