Q: Why do a lot of experts and CNBC commentators say the stock market is overvalued? How is the stock market valued?
A: Valuation is discussed a lot in today’s market environment. Whether it be the value of your home, a share of Apple stock, an ounce of gold, or a Bitcoin, many are wondering how you put an appropriate value on investment or use assets in an environment where prices are soaring in many asset classes.
There are only three ways to value an asset:
- Discounted future cash flows
- Use Value
- Speculating that something I purchase today, someone will be willing to pay more for tomorrow
Discounted Future Cash Flows
I understand this sounds technical and complex, but it simply means what am I willing to pay today for future income.
In a simple analogy, let’s assume that you could purchase a money machine. This money machine produces one dollar every day until the end of time. Each year, this money machine provides you with $365 with no effort or maintenance costs. How much would you be willing to pay for that money machine today? $1, $10, $3,000? I think we can agree that $1 would be significantly undervaluing such a machine as your investment would be recouped in a day and profitability would start on day two. I think we can also agree that you would not be willing to spend $5 million dollars on such a machine as you would need more than 13,600 years just to break even.
The fair value certainly falls somewhere between these two price points. For some, they may be willing to spend $1,000 and find they can recover their initial investment in 3 years. Others may be only willing to spend $700, while still others might go as high as $1,500.
The point is the exact fair price of the discounted daily dollar is up to the bidder of the device, but this is what makes markets. As the seller of such a machine, I want to find the buyer willing to pay me the highest price. As the buyer, I want to find the seller willing to sell at the lowest price.
Use value is simply purchasing an asset and using this asset to provide me or my family with a service. We purchase a house to provide us with a place to live and shelter us from the elements. Houses do tend to increase in value, but it is the use of that home that people value most. Besides, if we did not own our home, we would need to find shelter elsewhere and pay rent to provide that shelter.
Speculation is not nearly as complex. In this case, I purchase a Mickey Mantle rookie card, hold it for a while, and hope that someone is willing to offer me more (hopefully significantly more) than I paid. This very famous baseball card does not shoot off income. It simply sits….and waits. It has no use-value (I cannot use the card for any functional purchase such as heating my home or feeding my children).
These types of valuation methods are certainly oversimplistic but are a relatively simple way to help you understand how to value an asset.
Stocks, bonds, annuities, businesses, or any asset class that either now, or at some point in the future shoots off cash, is usually valued as a discounted future cash flow asset. Real estate and commodities (such as oil, coffee, or lumber) are often used assets. Speculations can come in any form, but in today’s world, we see much speculation in cryptocurrencies, collectibles, and precious metals. More traditional asset classes such as stocks and real estate can become speculations when prices of these assets become disconnected from their cash flow or use reality (i.e., eToys stock in 1999, real estate in 2006, and GameStop stock in 2021).
Even if a company, such as a technology company, that is losing money today or expects no free cash flow in the near future, it is still valued as an asset that is working to scale (grow) at such a quick rate it needs to burn a lot of cash now to stay ahead of the competition in a quickly changing and growing industry so someday it will be so large it will have significant cash to shoot off to its owners (shareholders). Excellent examples of these types of companies are Amazon (lost money for 20 years before their profitability exploded), Facebook, Microsoft, Google, etc.
Other companies such as Coca-Cola have little room for growth (the bushmen in Africa drink Coke) but they charge a very high price for sugared water thanks to the tremendous brand recognition they’ve built. This means free cash flow is paid to the shareholders in the form of dividends in large quantities.
Historically, the valuation of a company or group of companies is measured by the price to earnings ratio (P/E) which tells investors how many years it will take you to make back your investment through earnings at the current rate (please note this metric does not account for growth over time of these earnings). Historically, the S&P 500 has run at an average P/E ratio of 15-18 (It will take 15-18 years to make my money back at today’s earnings rate). During times where markets have fallen and are low, P/E ratios can fall into the single digits. During times like today and periods of strong economic growth and high speculation, P/E ratios can be in the mid-high ’20s. For individual stocks like Tesla, the P/E ratio may be 1,500.
Experts tend to say an asset class like stocks are overvalued in markets like today’s environment when P/E ratios and metrics like them tell us that historically, this is the highest price in relation to earnings people have paid. Investors are stretching to pay high prices for their money machine. This does not mean necessarily that the markets will crash (although they can), however, it does mean that people will accept far lower returns over time when purchasing an asset today. Unless they are bailed out by another buyer who is willing to accept even fewer returns in the future to pay a higher price today. This, however, now becomes speculation and can be very profitable in environments like markets today…until it’s not. When the music stops there will not be enough chairs for everyone.
There are far more metrics to consider than just P/E when trying to value an asset (such as current interest rates, the growth rate of earnings, future economic prospects, etc.). However, if you are simply purchasing an asset because it has gone up lately and hope someone else will purchase it from you in the future, understand you are a speculator, not an investor. Many have become wealthy speculating just as many have won large sums of money at the roulette wheel. However, luck plays a significant role in speculation and is not a solid long-term investment strategy. The great investors throughout history have been successful in purchasing undervalued assets.