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Price vs. Value

A Good Starting Point

P/E ratio analysis (both absolute and relative valuation) is not a silver bullet when it comes to stock picking. All else equal, it is of course better to pay less for a stock (or any ‘widget’) than more, so the ratio provides a 'quick and dirty' snapshot. At the very least it provides a starting point in the valuation process. It is worth noting that the P/E only considers the accounting earnings a company reports; at the end of the day what really matters is cash flow generation. Even better than cash flow, a firm’s free cash flow profile is a more quantifiable way to understand management's historical and future value-creation (or destruction) acumen. P/E market data is bountiful than other more nuanced valuation metrics.

Data Viz in Action

A nice way to communicate the meaning and hopeful value of any quantitative data is through data visualization. In particular, violin plots allow us to visualize the full distribution of historical valuations along with additional insights we consider when seeking index-level and stock-specific insights. Century Bank's Wealth Management Group has turned to the 'R' software environment for statistical computing and graphics. R is the global 'lingua franca' for data scientists. We believe possessing even the most fundamental understanding of its value empowers us to communicate often complex investment concepts in a more intuitive and user-friendly way for clients.
Below is a violin plot for the S&P 500 TR index:

Data Source: Bloomberg©

Initial Interpretation

Right away we can see the index’s month-end P/E has been between 15.2 and 18.2 50% of the time (last 10-years). How do we know this? Each horizontal line represents 25% of the observations so the observations between the top line and bottom line represent 50%. Furthermore, we see there is a tighter clustering between the middle and top lines, or 17.08 & 18.24. The width of the violin plot reflects the data observation frequency. But what about the most recent month-end valuation? What does the valuation look like today as compared to the last 120 observations, spanning 10-years? Is the market trading where it usually does, on average? By adding a statistical summary function we can now see March’s month-end P/E level:

Data Source: Bloomberg©

Layering the Analysis

First we learned about the distribution of the month-end P/E ratios. Now, adding some more code, we see the most recent month-end level. The interpretation is that based on this metric, the index is more expensive than usual. Given the fact the yellow dot is in the top quartile, we can conclude “the market has been cheaper at least 75% of the time compared to today’s valuation”. Going one more step, we finally add a vertical red line that spans “two standard deviations” from the average valuation. Without getting too detailed about what this means, it can be summarized as follows: the top of the red line represents the most expensive 2.5% occurrences while the bottom of the red line reflects the cheapest valuations. We are currently trading at the top of the line:

Data Source: Bloomberg©

Cleaning it up

We all like a nice looking chart, so let’s add the “Economist” theme to the plot and include attribution and a quantitative summary:

Data Source: Bloomberg©

Summary Statistics: Price-to-Earnings Ratio for the S&P 500 TR Index®
Min. :12.04
1st Qu.:15.23
Median :17.08
Mean :17.04
3rd Qu.:18.24
Max. :24.24
Last :21.76
Data Source: Bloomberg®

Conclusion

Aside from reassuring the readers that we are not trying to psychoanalyze them with an inkblot interpretation, the above discussion shares our valuation analysis process. As we stated above, a high P/E does not mean “sell stocks”. What may explain today’s high levels? First, the data we are looking at is ‘trailing P/E’ data. P/E ratios reflect future expectations. The “Trump Bump” has driven valuations higher because the investment community believes there will be corporate tax cuts, regulatory easing, and greater capital mobility. From our perspective, we currently believe there is more downside risk than upside potential given how difficult it is to legislate any change in D.C. As a result, our focus is to focus on companies with strong balance sheets and ones with superior cash flow generation. At the asset class level, it means ensuring we assess relative global valuations while constructing portfolios with a defensive posture should volatility rise.

Carl Hall, CFA
Chief Investment Officer

Wealth Management at Century Bank logo.

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The material provided on this website is for informational use only and is not intended for financial or investment advice. Century Bank and/or its affiliates assume no liability for any loss or damage resulting from one’s reliance on the material provided. Please also note that such material is not updated regularly and that some of the information may not therefore be current. Consult with your own financial professional when making decisions regarding your financial or investment options.