Determining Stock Market Valuations

By: C. Hunter

So this comes back to the question of how Wall Street does value stocks. The first thing Wall Street does is toss out the idea of the totality of the cash flows in future years and focus on the much less volatile accounting earnings measure of an arbitrary year (usually one year ahead, but this can vary based on the earning profile of the company). Dividing the current price of the stock by this "forward earnings" gives us the price to earnings or "forward P/E" ratio you will often hear quoted on TV. While it is not the only measure used, it is certainly the most prevalent as it is simple. When you hear someone saying "The market is fairly valued trading at roughly 18 times earnings" this is what they are referring to. The problem with this measure is there is very little intellectual justification as to what exact number is appropriate.

The most common of these are either looking back at historical values in history or a simple comparison relative to interest rates (the so-called "Fed Model" which compares the earnings yield of stocks to that of bonds, failing to separately account for both the increased volatility of stocks and the ability of the earnings to grow over time).

For a particular stock, the analyst usually looks at companies with similar growth rates or similar companies in different industries to find "comparables" which are then either tweaked higher or lower based on factors such as quality of management, size or stability of earnings. The problem is that this becomes the tail wagging the dog because everything is just viewed relative to everything else, not necessarily where they should be based on sound principals of finance. The big answer as to who really controls market valuation is that it is the retail investor, many of which do not know the first thing about stock market valuation, that really determines the market price. This is especially true today now that mutual funds have made it a practice to keep as little cash as possible on hand and will let inflows and outflows alone mostly control their net portfolio position. Stock market valuations are not the main factor driving the market, but it is the overall liquidity environment, a fact that was painfully obvious in the late 1990s when analysts betrayed their cluelessness on true market valuations by coming up with measures such as price to revenue or "price per click" to justify what was in reality just a liquidity bubble as emotional greed permeated the market.

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