ELF
Capital Management, LLC
(Endowment
Like Fund Management)
July
3, 2009
This is the ELF Capital Management,
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P/E Valuation 101: Beauty is in The Eye of the
Beholder
Is This Stock Market
Fully Valued?
Every night
we seem to hear that the market might be cheap, fully valued or expensive. Sometimes we hear all of those views in the
same evening by different pundits. When
this happens, how’s the average person to know what to believe?
In this
article, I won’t tell you who to believe and why. However, I can give you some direction with
how you might you might hazard a guess on your own.
Let me
start with the concept of valuation.
Traditional valuation analysis starts with the premise that the value of
any asset should be equivalent to the present value of that asset’s expected future returns or cash flows. In practice, there are a number of methods
and processes by which one can estimate valuations – some are quite involved
and some less. A rigorous approach would
involve seeking to value an asset from multiple vantage points. Yet, the average investor is often not
trained or patient enough to go through such a process.
Among the
simpler and more commonly used valuation measures is the Price to Earnings or
P/E Ratio. At its essence, it represents
the share value investors are willing to pay for a share of a company’s common
stock based upon that company’s expected annualized earnings. For example, if a company is earning $4 per
share, how much would you be willing to pay for a share?
The P/E
Ratio might just serve as a useful tool in answering this question and it helps
if you know one of the more useful ways to view it.
A Very Basic P/E Ratio Relationship
When much
younger and less informed, I tried perusing financial newspapers to compare the
P/E Ratio’s of the stocks I was interested in to that of others. Often, I applied my comparisons quite
indiscriminately. And, the result was
not very consistent or effective. At the
same time, I wasn’t really forming much appreciation for how the ratio could be
used or its significance.
What I
didn’t know, was that the P/E Ratio could be converted into an expected rate of
return yield. Let’s take a look at the
equation to elaborate:
Share Price /
Annualized Earnings per Share = P/E Ratio
For those
of you who are mathematically inclined, you shouldn’t have a problem following
this. So, if
Annualized Earnings
per Share / Share Price = Earnings Yield
Then, you
should be able to obtain the same result from this equation:
1 / P/E Ratio =
Earnings Yield
Now, when
you convert this ratio into a yield, you have a result that might look easier to
evaluate versus other investment opportunities.
You might even be able to compare the result to something like - bond
yields. Which leads me to introduce you
to a theory called the “Fed Model”. By
the way, you would only go through this trouble of converting the P/E ratio to
an earnings yield if you didn’t have historical or forecasted EPS data readily
available.
The Fed
Model theory asserts that the yield on 10 Year US Treasury Bonds should be relatively
similar to the S&P 500 expected earnings yield. This, in theory, is a method that can provide
you an indication whether equities are cheap, fully valued, or expensive. Under this theory, if the 10 Yr UST yield is
greater than the forward earnings yield of the S&P 500, then stocks are
expensive relative to bonds and vice-versa.
The theory is not perfect, but should give you a basis for developing
your own thoughts on the subject. Just
note that stocks are far less comparable to US Treasury bonds when it comes to risk
and that needs to be considered as well.
The More Important P/E Ratio
Consideration
First,
expected future earnings are more valuable than historical data. And, if working with forward-looking
earnings, how optimistic or pessimistic are the forecasts you’re getting?
Keep in
mind that we invest today with the hope that we will realize greater value in
the future. Like driving a car, unless
you desire to go backwards, it is safer to keep your eyes forward rather than
peering through the rear window.
Once you
are comfortable that you are working with forward-looking data, you have to
develop an opinion as to whether you think the forecasted data makes
sense. After coming off of one of the
worst market declines in a lifetime and comparable economic conditions, do you
think stocks are expensive? I know, I
know – the market is up more than 30% from the mid-March lows. But the market is also still more than 40%
lower than the October 2007 highs. Also,
I don’t get the impression that the consensus earnings estimates are overly
optimistic either. What’s your take?
Market Update
While the
second quarter of 2009 has treated us well, it now seems like the market might,
I say might, stall for a little while. I
don’t expect a free fall like we saw last March and in October, however, I’m
not entirely afraid to take some profits here and there and jump back into the
market on dips.
Many people
were sufficiently scared by the stock market’s actions over the past year and
many missed this quarter’s run up in prices.
My own feeling was that the markets had factored in a much harsher
outcome for the economy last March, and when it looked like a continued
downward spiral was less of a threat, the markets abruptly changed direction
and rallied. This caught many professional
and personal investors off guard and they missed the bulk of this rally. As a result, don’t be surprised to hear many
in the media try to talk down the market as doing so may be the only way they
can reclaim a market opportunity to buy at lower prices.
I don’t
think that the economy will make a rapid rebound from here as credit remains
tight, unemployment hasn’t seemed to peak yet and home prices continue to
fall. On the other hand, I think that
the economy is at the early stages of stabilizing and consumers and business
are just beginning work through having to rebuild their finances in this new
environment. Don’t get me wrong. I do see “green shoots” and, yet, it seems
like more than 75% of the “field” remains barren and the buzzards are still
circling. I am optimistic. Still cautious, but optimistic nonetheless.
Our portfolios
continued to move higher through June, and we finished the 2nd
quarter strongly. As such, I am happy
to report that – taken as a whole – our portfolios under management were UP
1.96% for the month of June. On a year-to-date
basis, we’re looking pretty good right now as well. Here are some comparative numbers for you to
review:
|
|
Jun 2009 |
3 Month |
Y-T-D |
1 Year |
|
ELF's
ETF Strategy (net) |
1.96% |
30.86% |
14.04% |
-20.75% |
|
S&P
500 |
0.02% |
15.22% |
1.78% |
-28.18% |
|
Russell
2000 |
1.34% |
20.23% |
1.77% |
-26.30% |
|
MSCI
EAFE Index |
-0.77% |
23.76% |
5.64% |
-33.55% |
|
|
-0.73% |
21.22% |
7.56% |
-31.09% |
For
disclosure purposes, past performance is not necessarily indicative of future
results and ELF Capital Management LLC (ELF), formerly Hoffman White &
Kaelber Financial Services LLC, cannot guarantee the success of its
services. There is a chance that
investments managed by ELF may lose a substantial amount of their initial
value.
ELF is an
independent discretionary investment management firm established in February
2003. ELF manages a strategic allocation
of primarily exchange-traded index funds (ETFs), and may invest in other
carefully selected securities. ELF may
also employ hedging techniques, through the use of short positions and
options. ELF manages individual
portfolio accounts for both individual and business clients.
The ELF ETF
Strategy returns presented herein represents a composite of actual results from
all client portfolios managed by ELF.
Currently, it is the only composite presented by ELF and separate client
account portfolio positions are substantially similar, except as may be
modified for retirement plan accounts and accounts with net equity of $60,000
or less. There is no minimum account
size for inclusion into ELF’s ETF Strategy composite and accounts with net
equity of $60,000 or less have a tendency to downwardly skew the combined
results.
The
performance data presented herein includes the reinvestment of dividends and
capital gains; as well, ELF’s ETF Strategy composite returns are presented
after deducting actual management fees, transaction costs or other expenses, if
any. ELF charges an annual investment
management fee as follows: 1.25% on the first $250,000; 1.00% on the next
$750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.
Broad market
index information provided is solely for the purpose of comparison. This index data was obtained from third party
sources believed reliable; however, ELF does not guaranty its accuracy. An investment account managed by ELF should
not be construed as an investment in an index or in a program that seeks to
replicate any index. In most cases,
investors choose a market “index” having comparable characteristics to their
portfolio as a benchmark. An ETF is a
security that tracks an index benchmark or components thereof. As ELF actively manages a strategic
allocation of primarily ETFs, selecting a comparable benchmark poses
significant challenges. Over time, the
broad market indices provided above may exhibit more, similar or less
variability of returns and risk than ELF’s strategic allocation. As well, the broad market index information
provided above reflects gross returns and have not been reduced by any
estimated fees or expenses that a person might incur in trying to replicate an
index.
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