Most traditional measures of market valuation revolve around some variant of P/E ratios, be it TTM, forward operating, or Shiller cyclically adjusted P/E ratio. While it can be useful for evaluating the relative attractiveness of equities at a point in time, it can mask valuations at the enterprise level, which we argue is the more important metric, and is not reliable for historical comparisons.
Looking at both enterprise value and market cap measures of valuation together brings a much clearer perspective to relative valuations over time.
Enterprise value basics
So what is enterprise value? The simple way to think about Enterprise Value, is that it is the value of the whole company or market, if you were to own it free and clear of debt.
The technical definition is that it is the market cap plus long-term debt minus cash. The debt will typically be at face value but could be at market value, if traded debt. Cash should only be excess cash that is not needed to run the business on a day-to-day basis.
So that's the definition: Market Cap + Debt - Excess Cash.
Enterprise Value versus Market Cap
This graph shows Enterprise Value versus equity value for the market as a whole (we are using nonfinancial companies only). The current Enterprise Value for the entire market is about $27 trillion of which about $22 trillion is equity, and that leaves about $5 trillion in debt, which is about 20%. It's about an 80/20 split between equity and debt. The gap is widening over time, which means companies have been taking on additional debt over the years.
Ratio of operating earnings to Enterprise Value
This is the key metric to observe. The graph below shows that it's been trending down for 50 years -not in a straight line but generally declining over time - and right now, is at a little above 5%. What it means is that investors are willing to pay almost 20 times operating earnings for the enterprise. It's pretty high, as you can see, relative to historical. The only time it's been that high before was in the tech bubble era, around 2000. So on an operating earnings to Enterprise Value basis, it looks relatively expensive, but let's look a little further.
Back in the late 1990's real GDP growth was around 5% whereas today it's around 2%
When we compare it to the tech bubble era in the graph below, the Enterprise Value multiple actually got a little higher back then, but the difference back then was that real GDP growth was closer to around 5% whereas today we are around 2%, actual and forecast.
So back then, the valuation might actually have been justified, 20 times operating earnings with a 5% real GDP growth rate, whereas today it's 20 times with a 2% real GDP growth rate - much less justifiable. In that context, today's valuations might actually be more extreme than the late 1990's, given that real GDP growth rate is much lower today.
Enterprise Value relative to sales or GDP is high too
The Enterprise Value multiple is currently about 1.5 times GDP, also high relative to history, except for the tech bubble. We don't actually use this measure in our analysis, but it does provide perspective.
Comparing the operating yield to the equity yield (inverse PE ratio)
It gets interesting when we compare the P/E ratios, or earnings yield, from the past 12 years to the 1960-1972 period both circled in black. You can see that the equity yields, shown by the horizontal red lines, are at similar levels, but the operating yield, shown by horizontal blue line, back then, was about double what it is today; it was closer to 11%, today it's about 5.5%.
There are two reasons why equity yields can be lower than operating yields:
1. Positive leverage from borrowing
This chart shows the difference between the operating yield and the corporate bond interest rate. The higher the difference, the more companies can enhance their return on equity by borrowing. All the way up to 1980, with one exception, there was a good spread between operating earnings yield and corporate bond rates, so companies could borrow at less than their operating earnings yield and effectively increase their return on equity - but since about 1983, it's been mostly flat, hovering around zero.
2. Higher growth expectations
Higher growth expectations would imply a higher enterprise value multiple, but would also imply an amplified P/E ratio, given existing leverage. We believe that recent growth is a reasonable proxy for future growth expectations, and this chart of historical real GDP growth implies slowly declining growth expectations for the past 50 years.
So in 1960 to 1970 you were paying 20 times after tax earnings for the equity, similar to today, but the actual value of the enterprise was cheap back then; it was 10 times operating earnings, versus today at 20 times. You were effectively buying the enterprise for 50% less than today. It's a similar picture in the 1986-1996 square, but less extreme.
Take a moment to think about this because historical comparisons of P/E ratios is meaningless in the absence of accounting for differing leverage and growth expectations.
The higher equity premium relative to Enterprise Value back then could be explained by a combination of higher growth expectations, which is likely given that real GDP growth rates during both those times were higher, and could also be attributed to attractive financing rates relative to operating yields - at least in the 1960 - 1970 period, which has the higher spread.
Note that the equity spread has actually been declining over time too, which we would argue is just representative of both lower growth expectations and the reduced ability to leverage earnings through borrowing.
From a valuation perspective, your margin of safety was so much better in the 1960 to 1970 period because you were buying the enterprise at 50% less than today - even if your return on equity was the same.
So in conclusion, separating out the enterprise first, puts valuations into a much better perspective. When performing valuations, always look first at operating earnings to Enterprise Value, and after that, go below the line to see if there is attractive financing that may have additional value.
Current low growth and thin margins between operating yields and corporate bond rates, lead us to infer that both operating yields and P/E ratios are richly priced. This doesn't mean that the market is going down anytime soon, but the outlook for the long term is constrained.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.