Written by: Philip Lockwood
The stock market and the real economic environment have an extreme disconnect right now. My goal with this month’s article is to shine some light on why the stock market is currently trading at the valuations it is, while the economy seems to be struggling. With this being said there are some stocks that are trading at what I would call absurd valuations.
The first and perhaps most important thing to remember is that economic data looks backward, while the market looks forward. It is easy to get caught up in your day to day reality and news headlines, but it is much more difficult to think of what the future will look like 12 months from now. Let me guide you into four areas I am looking at to justify the value of some of the stocks in your portfolio.
1) Savings Rate –
While the pandemic has increased unemployment to above 8% (https://www.bls.gov/news.release/pdf/empsit.pdf) there have been many programs put in place that have dulled the impact of a normal surge in unemployment. Those things being the additional $600 a week that folks were getting in unemployment pay. Americans have been saving lots of money during the COVID-19 crisis. The savings rate – the portion of monthly income that households are socking away – hit a record 33.5% in April before edging down to a still outsized 19% in June, according to the Commerce Department figures. As a baseline Americans were saving an average of 7.5% before the pandemic. From March through June, the latest data available, U.S. households banked an additional $916 billion of their income above pre-COVID levels, according to Moody’s Analytics, a stack that will top $1 trillion when July figures are included.
This increase in savings rate is seen as a silver lining and is much different than previous recessionary periods. The thought is when it is safe for people to go out and spend money they will do it in a fashion we have not seen for some time.
2)Risk Free Rate –
There are many people scratching their heads when they see valuations of stocks justified by 2024 earnings or even 2025 earnings numbers. Their instinctive reason is to dismissive, but I believe that is lazy thinking. When you put all of the data together it creates two trends:
- People become open to looking further in the future for a company to deliver cash flows – hence pricing stocks on 2024/2025 models today vs when rates were 6% (those models looked out 2 or 3 years max)
- Investors, frustrated with a worthless risk-free rate, become increasing biased to equities.
All of this can change quickly, especially if rates rise but we’ve just been told by the Fed that they will be more permissive with low rates for the time being. In summary risk free rates are important when you consider stock valuation. The risk-free rate today is 0 or near 0. As rates go down, people tend to model equity returns over longer periods of time, the opposite is true as the risk-free rate increases.
3)Companies are saving money by employees working from home –
Covid-19 has brought about many changes in life, one welcomed change by both employers and employees is that ability to work from home. Many of these employers are looking at the employee’s happiness and productivity levels and are finding that both are at or near all-time highs without the expense of the real estate required under the previous model.
In theory that all sounds great, but the question is what is the validity of our theory? When we look at the research provided by the world’s top researchers (This collection of statistics was sourced from the world’s leading research institutions studying the topic of telework, including Gallup, Harvard University, Global Workplace Analytics, and Stanford University), the data says yes, by providing workplace flexibility you will boost your bottom line in these 5 categories.
- Productivity— Teleworkers are an average of 35-40% more productive than their office counterparts and have measured an output increase of at least 4.4%.
- Performance— With stronger autonomy via location independence, workers produce results with 40% fewer quality defects.
- Engagement — Higher productivity and performance combine to create stronger engagement, or in other words, 41% lower absenteeism.
- Retention — 54% of employees say they would change jobs for one that offered them more flexibility, which results in an average of 12% turnover reduction after a remote work agreement is offered.
- Profitability — Organizations save an average of $11,000 per year per part-time telecommuter, or 21% higher profitability
The data shows us one reason that stocks may be at higher valuations even as companies are going through the rigors of Covid-19. The virus has forced a fundamental shift in the way we work, and that shift is benefiting companies and employees alike.
4)Stock Valuation Metrics –
I remember back to my days at the Tippie Business School when I was learning about stock valuation. My professors always reminded us that a company’s cash flows over the next 12 months is only a small piece of the value of a stock. You are paying for the cash flows in the next 12 to 24 months when you are buying a stock: The Company’s Future Cash Flows.
One of the industry standards for figuring out the proper price for a stock is using the price-to-earnings ratio. The price-to-earnings (P/E) is arguably the most popular method for valuing a company’s stock. Let’s go through the basics of valuing a company’s stock with this ratio and work out how this calculation can be useful to you.
Calculating the value of a stock
The formula for the price-to-earnings ratio is very simple:
Price-to-earnings ratio = stock price / earnings per share
If you want to rearrange the equation to give us a company’s stock price, then use this formula:
Stock price = price-to-earnings ratio / earnings per share
After looking up the company’s trailing-12-month earnings per share, next we need to look up the company’s P/E ratio. For the sake of understanding the ratio, you can use the P/E ratio listed on many of the financial websites out there today.
If you use a company’s current trailing-12-month earnings per share and P/E ratio, you aren’t learning any new information about the stock. If you analyze a company’s future earnings potential and how the market values its competitors, you can use the P/E ratio to understand where you think the stock’s price could be in the future.
For example, if the company has a major new product release coming next quarter, you could predict how that release may increase its earnings per share going forward. Most likely, your research will indicate a range of possible earnings per hare predictions based on the projection of the product release. This is why many companies will offer future projections on their quarterly conference calls.
This is why a stocks value is almost always an estimate of its growth rate sometime in the future. Normally I see the “forward P/E ratio” being forecasted 12-24 months out but with a risk free rate near zero and little insensitive in other fixed rate options (CD, Government Bonds, Savings Accounts, Etc.) many people will forecast future earnings even further than 24 months and that is what is happening right now, the non-existent return on the risk free rate is actually leading to higher company valuations.
With all of that being said it is impossible to predict the future, so there is no guarantee that any stock will perform as you predict. However, using the P/E ratio to value a company’s stock in variety of different situations can be an effective way to compare a stock to its’ competitors.
The combination of the savings rate, risk-free rate, increased company profitability per employee and the stretched valuation metrics lead to many of the current stock prices you see today. The next and final question is what changes this? Well there could be many contributors to a downturn in the market but one of the main things to look out for would be an increase in the risk-free rate. If this were to increase, then we would likely see some money flow out of equities into more fixed investments as the fixed income space can offer more attractive returns than the current near zero rate they offer today. There are many other “outside” factors than can influence the market but if we are looking at what the current market environment looks like today and what could change that outlook, I think the Federal Reserve holds the key.
Securities offered through Parkland Securities, LLC, member FINRA (FINRA.org) and SIPC (SIPC.org). Investment Advisory services offered through SPC, a Registered Investment Advisor. Lockwood Financial Strategies, LLC is independent of Parkland Securities, LLC and SPC
It is important to remember that past performance does not guarantee future results. Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type. Please consult with your tax professional before any decisions are made.
Philip Lockwood | Founder + Managing Partner
Address: 3100 Ingersoll Ave. Des Moines, IA 50312
Website: Lockwood Financial Strategies