I wrote this post and developed the methodology described herein to answer one simple question: how much are your stock market investments really worth? The answer to this question has profound implications for your financial future.
Here are a few common ways to determine the valuation for a stock.
The Efficient Market Hypothesis
The question of valuation often comes down to one simple question – are the current prices for your stocks an accurate representation of their actual value?
Basic economic theory tells us that something is worth whatever another well-informed person will pay you for it. If you’re selling an old desk on Craigslist for $100 and somebody pays you $100, then the desk must be worth $100 (actually, it’s more accurate to say it must be worth AT LEAST $100, as the other person might have been willing to pay more than $100 but you were willing to sell it for $100). By this logic, if 1 share of Microsoft stock is trading for $100/share, then it must be worth $100/share.
Other people address the question of stock valuation using the Efficient Market Hypothesis (EMH). The basis of the EMH is that a stock’s current price reflects all relevant information about the stock. Thus, at any given point in time, a stock’s price is “correct”, as it reflects all known information about the stock.
Frankly, I think the EMH is complete bullshit. Why? Well, look at this:
This is the value of the S&P index, adjusted for inflation, since 1880. Notice the dramatic swings around Black Tuesday in 1929 (the start of the Great Depression), Black Monday (1987), the Dotcom crash around 2000, and the Great Recession around 2007. Unlike the downturns around World War 1 (1914-1918) and World War 2 (1939-1945), none of these events was precipitated by an outside event. I suppose you could argue that the Tech Bubble crash was exacerbated by the 9/11 attacks, but the stock market had already peaked in March, 2000 and was headed down before 9/11. Rather, the markets became overvalued and then corrects fast and hard.
Here’s the reality – if the market was truly efficient, how could dramatic swings like this exist? How does the stock market get dramatically overpriced (and underpriced)?
Dividend Discount Model
It’s generally accepted that the value of an investment is the current value of all future income that it provides (this is the Dividend Discount Model). Although this is a pretty straightforward idea, it can still result in wide variations in value because not everybody will agree on what the expected future income of a share of stock will be.
Stocks that don’t currently provide income still have value because the expectation is that these investments will eventually pay an income. Amazon does not and has never paid a dividend, but investors are willing to own Amazon’s stock because the assumption is that some day Amazon will pay enough of a dividend to justify today’s price. Of course, a dollar today is worth more than a dollar tomorrow, so when calculating the value of future income you must discount the future income to today. For example, you might decide that $1 of income next year is worth just $.90 to you today, so if you were to invest in a bond that pays you $100 in 1 year you would be willing to pay up to $90 today to buy that bond today.
During the stock market crash that started in 1929, stocks dropped about 80% from their highs to their lows. If we believe the market is efficient and rational, and if we use the Dividend Discount Model to value our investments, then we’d need to believe that the people of that time believed that the value of future profits had dropped by 80%. While the economy of the time was clearly terrible it’s both obvious now and must have been obvious at the time that the US economy would not produce 80% less stuff permanently.
What about the Great Recession that started in 2007? Well, the Dow hit its pre-recession high on October 9, 2007, closing at 14,164.43. Less than 18 months later, it had dropped more than 50 percent to 6,594.44 on March 5, 2009. Was it reasonable to believe that the US economy in 2009 was going to permanently be less than half the size it was just 2 year before?
Of course not.
Something else was going on.
Prices changes due to profitability
Another possible explanation for swings in the price of the S&P 500 index is that the profitability of the companies in the index is changing. All else being equal, if a company is making 2x as much money as it was before, then you should be worth 2x as much money. So, if the prices of stocks were fluctuating at the same rate as the profitability of the stocks then the price fluctuations would be rational.
Let’s take a look at the inflation adjusted earnings of the S&P index compared to the inflation adjusted value of the S&P index.*
Clearly there is a relationship between earnings and the value of the index. However, it’s equally clear that it’s not a direct and exact relationship. There are times (like from around 1970 to around 1980) where earnings are increasing but the value of the index was decreasing. Then there are more recent huge fluctuations in earnings during the Dot Com bust around 2000 and the Great Recession around 2007-2009 where earnings rose and then fell faster than the underlying index.
Investment returns
The return from any investment is comprised of 3 components:
- Income (dividends, interest, etc.)
- Change in price. This can be further broken down into
- Valuation
- Profitability
A few simple examples might be helpful. Let’s say you buy a 1 year bond at par (for $1,000). The bond pays 10% interest. In 1 year you will get your principle back ($1,000) plus 10% interest. Your total return is 10% (we are ignoring inflation for now). All of your return was income and there was no change in price.
Next you buy 1 share of stock X for $10. Stock X generates $1/share in profit each year. You are paying $10 for each $1 of profit. Over the course of the next year Stock X generates $2 in profit per share and the price is $20/share. The stock is still selling for $10 for each $1 of profit. There was no income from the stock, and the valuation is unchanged, so all of your return was due to the increase in profitability of the company.
Finally, let’s say you buy 1 share of stock Y for $10. Stock Y generates $1/share in profit each year. You are paying $10 for each $1 of profit. Over the course of the next year Stock Y generates $2 in profit per share (still no dividend) and the price goes to $30/share. The stock is now selling for $15 for each $1 of profit. The PE ratio of the stock has increased from 10 to 15. Investors are willing to pay more per dollar of income than they were before.
Is Stock Y really worth $15 per $1 of profit when it was worth $10 per $1 of profit previously? Maybe, maybe not. Maybe the company is growing faster than it was previously. Maybe margins are improving. Maybe interest rates are dropping. We’d have to look at a lot of company specific details to know if the company deserves a higher valuation today than it previously had.
But we look at averages across the entire stock market then all those company specific details disappear. Some companies grow faster (and warrant higher PE ratios) and some companies have their growth slow down (and deserve lower PE ratios). Overall, these individual fluctuations tend to cancel each other out. By looking at market indexes we can start drawing broad conclusions on how the market is valued at any given time and where it “should” be valued.
We can easily see this trend on a graph of the PE ratio of the S&P index over time.
The amount of money investors are willing to pay for a dollar of earnings has varied widely over the years. The lowest PE for the S&P 500 was 5.31 in December of 1917 (just after the US had joined World War 1). The average PE ratio for the S&P 500 from 1900 to 2017 was 15.86. The PE ratio as of August, 2017 is 23.6.
This means that investors are willing to pay 48.8% more for a dollar of earnings today than they’ve been willing to pay, on average, over the last 117 years. To give you some perspective, the S&P 500 went from April 1934 to December 1991 without ever once reaching a PE as high as 23.6. The market went for over 57 years, through multiple recessions and expansions, booms and busts, and was never once as expensive as the stock market is today.
If somebody held a gun to your head and forced you to guess what the average PE ratio would be over the next 117 years, what would you say? Do you think that investors will be permanently willing to pay $23.60 for each $1 of earnings, as they are today?
Personally, I’d guess that average valuations in the future are going to be right around right around a PE of 15.86. It’s hard to imagine that valuations over the next 117 years are going to be dramatically different from the last 117 years. Sure, there will be times when valuations are high, and there will be other times when valuations are low, but on average I’d expect that the average PE ratio of the US stock market in the future will be pretty darn close to the average in the past.
What does this mean for us?
Well, if we assume that the PE ratio of the market will eventually return to its long-term average then we can create a better way to value our investments.
Introducing the Money Commando True Wealth Index
I developed the Money Commando True Wealth Index (MCTWI) to more accurately measure and track the value of stock market investments.
The problem is that, at any given time, the price of a portfolio of stock investments includes both the value of the stock’s current and future income stream as well as a valuation multiplier. What we need is a way to remove the fickle fluctuations in the valuation multiplier so we can get a better idea what our investments are fundamentally worth.
This is where the MCTWI comes in. The MCTWI provides a simple way to adjust for high or low valuations when calculating the value of a diversified portfolio of stocks.
Calculating the MCTWI is easy – it’s just a percentage showing how much higher or lower the market’s current valuation is than the long-term average. We find the percentage by taking the S&P 500’s long-term average PE and dividing by the current PE. As we saw above, the long-term average PE for the S&P 500 index is 15.86. As of the end of August the S&P 500’s PE is 23.6. This means the MCTWI is 15.86/23.60 = .672. This means that around 67% of your stocks’ price is due to their actual economic value and the other 33% is due to an abnormally high PE ratio. To remove the effect of changes in valuation from your investments you just need to multiply the value of your stock investments by .672.
If you have a $1,000,000 portfolio then the MCTWI tells us that the portfolio is actually worth around $1,000,000 * .672 = $672,000. This is the number we would use when calculating net worth, determining withdrawal rates, etc.
The MCTWI will not always result in a reduction in the value of a portfolio. If the current market PE is lower than the average PE of the S&P then the real value of a portfolio will be HIGHER than the current value.
Advantages to using MCTWI
Using the MCTWI provides a more accurate representation of the value of an investment portfolio, and a more accurate valuation has a number of advantages.
- A more accurate valuation will also be a more stable valuation. Using the MCTWI will result in a portfolio valuation that is less affected by irrational exuberance or pessimism.
- Net worth is used to determine if/when to retire and now much money can be withdrawn each year during retirement. If your investments are worth less than their current price then you need a more conservative withdrawal strategy in retirement. Conversely, if your investments are actually worth more than their current price then you can pull more money out of your portfolio without needing to worry about running out of money.
For example, the 4% rule states that a retiree can withdraw 4% of their initial portfolio value in the first year of retirement, then annually adjust the amount for inflation. As I’ve written about before, the main issue with the 4% rule is that if your initial withdrawal amount is too high you’ll deplete your portfolio too early. And your initial withdrawal amount will be too high if your calculation of your net worth is too high. The MCTWI solves this problem by providing a more accurate net worth. Taking out 4% of the value of a portfolio based on MCTWI is significantly safer. In fact, using the MCTWI to calculate your net worth might actually lead to a higher sustainable withdrawal rate. I’ll be investigating this in more detail in a future post.
Another common retirement issue is the sequence of returns risk. This is very similar to the issue with the 4% rule discussed above – you retire when valuations are high and shortly after retirement valuations decrease. This means the price of your investments drops and you no longer have as much money as you though you did. The MCTWI solves this problem by removing the effects of high or low valuations from the calculation of net worth.
Potential issues with MCTWI
There are a number of limitations with the MCTWI that I’ll be addressing over the course of the next few months.
First, the MCTWI only applies to US stocks. A separate index will need to be created for foreign stocks. This is because the price of foreign stocks depends not only on the underlying economics and the valuation, but on the exchange rate of the foreign company’s currency.
Second, a different index will need to be created for bonds. In some ways bonds are easier to analyze, as interest rates have traded in a set band over the last 100+ years. In other ways bonds are harder to analyze, as bond prices rise and fall with interest rates, but if held to duration they return their interest rate.
Third, the MCTWI works best for portfolios that are relatively similar to the S&P 500 index. This means it’s most appropriate for diversified large-cap portfolios. It’s slightly less applicable to mid-cap/small-cap stocks and still less applicable to concentrated portfolios (where the valuations of individual stocks would become more dominant) .
Fourth, the MCTWI requires a long time horizon. After all, just because the market is currently overvalued today doesn’t mean it won’t get even more overvalued tomorrow. As John Maynard Keynes said – “The market can remain irrational longer than you can remain solvent.” However, it’s reasonable to expect that over a long period of time the market will always eventually return to and generally fluctuate around a PE ratio near the long-term average.
Finally, I need to analyze how to calculate proper valuation for real estate. I’m considering creating a ratio based on the cost of housing vs. average income. If housing in an area is normally 4x the average yearly household income and the cost of housing is currently 3.5x the average yearly household income then housing is cheap.
Conclusion
I believe that The Money Commando True Wealth Index is a big step forward in being able to properly value the equities portion of a portfolio. It provides a more accurate and less volatile measurement of net worth than existing mechanisms.
In all future net worth reports I will be showing both our “regular” net worth as well as the MCTWI adjusted value. I’ll also be publishing the MCTWI every month so you can use it to track your own
*All of the data used in the calculations above were compiled by Robert Schiller (yes, THE Robert Schiiller who won a Nobel Prize in Economics). He’s created a huge database of prices, dividends, and index values dating back to the late 1800’s. You can get his data at (http://www.econ.yale.edu/~shiller/data.htm).
What are your thoughts on the MCTWI? Does the methodology make sense to you? Will you use it when evaluating your own finances? Is it tough to look at your current portfolio and realize it’s worth about 33% less than you thought it was? Do you have any thoughts/ideas for how to better value bonds and/or real estate?