Musings On Valuation

Before we begin, we ought to readily confess that markets can stay irrational longer than we can stay solvent.

That said, the question on everyone's mind is how far can this rally go?

A back-of-the-envelope way to answer this question is to look at the major individual constituents of the indices; the companies that really move the needle. In the instance, let's look at the Dow 30.

Starting from 3M and going all the way to Walmart, we find an average PE* of 21.4x.

Well, that number is skewed to the high side by companies like VZ (PE of 92x) and AA (PE of 67x) whose earnings are likely depressed by so-called one-time events. Let's toss out those outliers, shall we, and also let's lose HPQ (negative earnings, PE meaningless) and then what are we left with? An average PE of 17x.

It is at this point that the cocktail circuit conversations switch to the long-term average PE ratio and how we're right around there aren't we and can I please have another of those delish hors d'oeuvres?

Except (a) what is the meaning of an 'about average PE' without an understanding of where we are in the cycle, and (b) did those periods of history include such fun things as trillion dollar stimulii and also large and growing unfunded pension liabilities -- liabilities which are deemed non-interest bearing and so excluded from many EV calculations -- representing a non-trivial and priority claim on the assets and future earnings of the companies?

(Answers: (a) good question (b) nope)

We're talking about companies in which the average EBITDA** is $19.8 billion (ignoring the two banks, BAC and JPM, where EBITDA isn't meaningful as a metric). Stop and think about that for a minute.

What does it take to grow a $20B EBITDA by high single digits or low double digits every year for years and years? And, if investors find that it's hard for giant companies to keep adding a billion and a half dollars (and more) in EBITDA every year what might be the fate of this 'about average PE' that we are so sanguine about?

So many questions.

*Let's not even argue the gap between reported PE and actual Free Cash Flow; just accept they're the same and bury your data-driven or philosophical objections.

** EBITDA is another proxy for the cash earning power of a business. It's hardly perfect, but then no proxy metric is. We could use another metric, and the broader argument would remain unchanged.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I have reduced my exposure to the broader US equity market. If or when the market disagrees I will reconsider that position.