What’s It Worth? A Guide to Valuations in Low-Visibility Markets

by Michael Msika, Anooja Debnath, 5/6/20

Is it cheap or expensive?

It used to be a question that strategists answered with a simple formula, but it’s turned into a fool’s errand. The S&P 500 Index’s 12% rally in April and sharp fall in profit estimates sent its forward price-to-earnings ratio to the most expensive level in almost two decades. In the words of Muddy Waters Capital founder Carson Block, “It makes no sense.”

Still, investors want to know what an asset is worth even in a world where there’s an unprecedented level of uncertainty on earnings, monetary policy and economic activity -- and analysts have had to get creative to deliver them.

Stocks: Thinking Outside the Box

Bottom-up equity analysts tend to be behind the curve in adjusting their earnings estimates to a negative economic shock, usually doing it well after the market prices in a drop in corporate profits and sales.

This means the widely-used ratio of price-to-estimated earnings tends to indicate stocks are cheap at first, before analysts scramble to slash forecasts, causing the metric to surge higher again. The measure becomes irrelevant, particularly with so much uncertainty surrounding the pandemic and the future business environment.


Bloomberg

Dividend yields, previously a stalwart of European companies known for their lofty payouts, have also been rendered impotent. A third of companies in the Stoxx 600 have canceled or postponed dividends, while other big names such as Royal Dutch Shell Plc cut theirs. Strategists are warning that more dividend cuts and cancellations are coming, which means investors can no longer rely on the yields metric as a guide to picking stocks.

So what are analysts turning to instead? Price-to-book and cyclically adjusted P/E are both “more reliable metrics” than P/E during times of elevated earnings uncertainty, according to Barclays Plc strategist Emmanuel Cau.

Discounted cash flow is a useful method for estimating the value of an investment based on projections of how much money it will generate in the future, according to Oddo BHF’s Sylvain Goyon. But this means more homework for investors, as the metric is only useful when looking at a stock-by-stock basis instead of an overall market or sector.

In such turbulent times, purchasing managers indexes can turn out to be more useful than regular valuation metrics to trigger buy and sell signals, especially for cyclical sectors such as autos and basic resources, according to Bank of America Corp. strategist Sebastian Raedler.

History suggests that even modest improvement in PMIs point to a rally in equities. It will certainly be a low bar for gains -- the JPMorgan Global Manufacturing PMI measure slumped last month to the lowest since the financial crisis more than a decade ago.