Joel: Brian, there’s been a lot of volatility in the stock markets to begin 2014 – lots of highs and lows. How do you know, if you’re an investor wanting to get into the stock market, when to get in?
Brian: I think one of the major problems investors have is they spend too much time talking about when based on where markets are going or where markets may have come from. In other words, they’re timing the market.
Perhaps a better way to look at an appropriate time to buy – or sell, for that matter – would be to focus more on valuations of the securities themselves.
Joel: So you can see how much the stocks cost, the prices. But how do you determine valuation?
Brian: Well, there’s any number of ways that professionals will determine valuations, but let’s, keep the conversation fairly simple. When buying a stock, what you’re really doing is buying a corporation and an anticipated stream of income from that corporation.
So you have some future value of a stream of income, which you have to then translate into some value today. So in order to do that, you’ll discount that future value by some rate of interest. So determining values is really a discounting mechanism of future corporate earnings.
Joel: So when commentators are talking about the stock market being too expensive, the Standard & Poor’s 500 index, what are they talking about?
Brian: I’ll hear lots of commentators talk about price-to-earnings ratio. So the price-to-earnings ratio, or the P/E, is merely how much are you willing to pay for a dollar of earnings in today’s world?
So you’re putting price over earnings – P/E.
Joel: So they’re looking at historic averages and comparing that to what the P/E is now?
Brian: Certainly. That’s one way to make that comparison. The historical price-to-earnings ratio on the S&P 500 is give or take 15. So you’re willing to pay $15 in any normal day for a dollar’s worth of earnings. That happens to be about where the market is today with the current value of the S&P over the projected earnings for the next 12 months.
Joel: But what about what you were saying about interest rates?
Brian: Well, interest rates play into the factor of whether valuations are fair or not fair. Interest rates are one thing that a lot of people aren’t giving consideration to when comparing those price-to-earnings ratios today.
In other words, the 15-times earnings we’ve normally paid in the past for stocks is based on normal interest rates. We certainly are anything but in a normal interest rate environment, so when trying to put some value to that discounting mechanism, discounting by a smaller rate of interest allows you to pay more for the asset today.
In other words, with a low interest rate environment, a fairer P/E might be more 17 or 18, given current interest rates. So you’re focusing on what you’re paying for the stock. You’re focusing on what the earnings of a company are. And you’re focusing also on the interest rate, or the discount mechanism, for current valuations.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted March 27, 2014)