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"Price is what you pay. Value is what you get." -Warren Buffett

People perceive "the stock market" in a wide variety of ways. Some call it a game, rigged and manipulated by insiders on Wall Street. Some see it as a wellspring of potential opportunities for profit (others for loss). There are even those who see investing in the stock market as outright gambling. All of these perspectives probably hold some shred of truth as most of them have been forged in the fires of personal experience. But when it comes down to it, understanding the stock market is as simple as understanding what a stock is - and then understanding how and why people assign value to it.

A common stock is simply a share of ownership in a company. That's elementary, but honestly it seems like many investors are in need of this simple reminder. By purchasing a share of stock one lays claim to a pro-rata share of the company's net assets and future earnings. All else equal, there is a positive correlation between how much a company owns and earns to what its stock is worth. Therefore, understanding how a company makes money can provide some insight into its intrinsic value.

Investors have different opinions on the "intrinsic value" of each stock based on differing views of future profitability and growth. This is why the price of a stock can change dramatically day to day even though the underlying fundamentals of the business may not have changed at all. At the end of the day, the price of a stock will be related to its fundamentals but will ultimately be determined by investors deciding what they are willing to pay for a pro-rata share of those fundamentals. We refer to this as "valuation," and one of the most common ways of measuring this is the "Price-to-Earnings" (P/E) ratio. This ratio measures how many dollars are being paid for every one dollar of earnings per share; so for a stock carrying a P/E of 15 investors are paying $15 for every $1 of earnings-per-share earned by the company. P/E ratios can differ dramatically from stock to stock (as they should), but perhaps more interesting is how the P/E ratio for the market as a whole can vary over time. There is a simple argument to be made that it's better to invest when the market's P/E ratio is low (cheap) than when it's high (expensive). In other words, valuation matters.

The chart below breaks down 140 years of stock market history into valuation quintiles ranging from the cheapest 20% of the time on the left hand side to the most expensive 20% of the time on the right. The vertical bars show the annualized real return that was realized on average over the subsequent 10-years for each valuation regime. The chart reflects a clear relationship between valuation and long-term expected return; that is, the cheaper the valuation at entry point into the market, the more money you should expect to make going forward.

(click to enlarge)

One of the big reasons for this is found in the expansion and contraction of the P/E multiple itself. Stock market performance over any time period can be broken down in terms of the change in the underlying earnings-per-share and the change in the P/E multiple. As shown in the matrix below the best possible scenario is when earnings are growing and P/E2012-11-20_Earnings_Multiple_Grid.png multiples are expanding; this is when stock investors make the most money. Vice versa, if earnings are declining and P/E multiples are contracting then the market is facing dual headwinds.

The stock market currently carries a multiple that is reasonably close to its long-term average. That is to say, it is neither excessively cheap nor expensive. However, in looking back over the past 12 months it has clearly been multiple expansion that has driven performance. As shown in the chart below the P/E ratio on the S&P 500 (SPY) expanded from roughly 14 to 16 over the twelve months ending 10/31/12. This represents an expansion in the P/E ratio of close to 15%, which corresponds nearly perfectly with the total return for the index.

(click to enlarge)

On the flip side, corporate earnings declined year-over-year in the third quarter (the first decline in eleven quarters). Without earnings growth, any further upside in stocks would have to be driven by even more multiple expansion, meaning investors would have to be willing to pay higher and higher prices for the same level of earnings. We foresee a number of risks to this outlook as profit margins are already stretched and companies are having a harder time sourcing top line revenue growth in a feeble global economy. Even so, consensus analyst estimates are still projecting 10%+ earnings growth in 2013. Those estimates have been steadily declining with every revision, a trend we would expect to continue into next year. We will dig into more detail on the specific headwinds to future earnings growth in next week's post.

Original Source: Valuation Matters

Source: Why Valuation Matters

Additional disclosure: Transparency is one of the defining characteristics of our firm. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments or its principals. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.