“How much?” not “When?”
By Brian D. Kilb
When discussing investment opportunities, clients constantly ask us, “When is the right time to buy?” My answer (almost) always: “Buy when it’s cheap. Sell when it’s expensive.”
You’ve heard before that it’s next to impossible to time the market. In the short run, too many uncontrollable events drive emotion-dominated buying and selling. Too often, emotions motivate irrational, sometimes excessive reactions to events. Since you can’t control or predict those events, you can’t make intelligent decisions based on them.
So what should drive buying and selling decisions? Valuation.
Valuation is all about buying low and selling high. The difficulty is determining what’s cheap and what’s expensive.
When you buy a company’s stock, you are buying the anticipation of future earnings for that company and discounting that expected stream of income to create a present value.
Absolute vs. relative
Creating a precise valuation for a company would be putting an absolute value on that company’s stock. If we had an exact idea of what each stock was worth, we could then buy when it’s at a lesser price and sell when it’s higher. But so many variables enter into determining a precise value that it can become impractical.
Especially when talking about asset classes or whole markets, it makes more sense to look at valuations in the aggregate using relative valuations, not absolute.
Determining relative valuations is a matter of comparing current values against a historical average or benchmark. We are still concerned about earnings, but now we focus on the combined earnings of each of the companies in the market.
Analysts are constantly revising their projected earnings for the companies they follow. We can compare those projections with current valuations to get a sense of overall relative worth.
For instance, the S&P 500 earnings forecast for 2011 is slightly below $100. As I write this, the market sits at 1,187. If I divide market value (price) into forecast earnings, I get 11.87 (1,187/100), which suggests people are paying $11.87 for every dollar of earnings in the S&P. That’s what’s known as the price-to-earnings ratio or P/E.
Now the fun part. If we compare the current P/E to historical P/Es, we can get a sense of how cheap or expensive the marketplace is. Data from Yale University economist Robert Shiller says the historical median P/E for the S&P 500 is 15.8. That means stocks in the S&P are trading at approximately 75% (11.87/15.8) of their historical norm.
This sort of comparison can be done on many levels. I love to compare stock valuations by different investment styles. The charts below break down relative stocks valuations by large- and small-companies and by value and growth.
You can see the relative worth of each subgroup by comparing its P/E to its historical norm. For instance, as of Sept. 30, 2011, large-cap growth stocks were trading at 63.5% of their historical norm against 86.8% for small-cap-value stocks. While each stock category looks relatively cheap, large cap-growth looks cheapest.
Valuation over timing
This may be an oversimplified tool for a very complex set of data and variables, but a simplistic overview often can keep things in proper perspective.
With a properly balanced investment portfolio, you shouldn’t have to worry about timing the markets. But when opportunities arise for rebalancing your portfolio or making other adjustments, relative valuations can be invaluable.
Once you know what something is worth, you have a much better guide to whether the market is at a discount or premium. Knowing that you’re buying cheap or selling expensive securities will remove your doubts about the timing of the transaction.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
initially posted Oct. 12, 2011
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Also on Landaas.com
Valuing the Market – further explaining the use of price/earnings ratios to gauge whether securities are relatively cheap or expensive
Value Investment Strategy – on the role that value-oriented stocks play in a portfolio
Investing in Growth – on growth companies and how their stocks can figure into an investment plan