Your Take: Why Equity Valuations Matter

Louis Green, wealth manager at Savvy Advisors, brings valuations back into focus.

When considering how to invest in the current market environment, it’s important for investors to consider valuation in their analysis. Simply stated, this means placing a value on a company or the stock market in its entirety.

Popular valuation measures include price-to-earnings (P/E), price-to-book (P/B) and the price-to-cash flow (P/CF) ratios. To determine any one of these ratios, investors can divide the price of a company’s stock by the appropriate metric (earnings, book value or cash flow). Another popular metric, used to measure the entire market’s value, is the total U.S. stock market value divided by gross domestic product (GDP).

The Big Picture: Why Valuations Matter

Understanding stock market valuations is critical for investors for many reasons, one being the correlation between long-term performance and current valuations. Correlation is a measure of the relationship between two numbers. The great value investor Benjamin Graham is known for stating that: “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”

Critical Moments: When to Focus on Valuation

We think there are especially notable times to consider stock market valuation, such as in extreme market environments marked by volatility. The dot-com bubble of the late 1990s, for example, would have been a great time to measure the valuation of any of the popular companies because many of these businesses had little or no earnings in comparison to their prices. Investors were paying extremely high valuations and betting on future growth, much of which did not come to fruition.

Another great time to consider stock market valuations is after significant market declines. While it is very difficult to invest new money in declining markets, those same declines might provide an opportunity to invest when stocks are on sale.

Game Plan: Using Valuation for Strategic Investing

Other ways to use valuation in your investment decisions include performing company or sector comparative analysis against historical valuation, peers or other sectors, as a diversification tool. Investors might consider the valuation of any company or sector they wish to invest in, and then weigh the impact of that purchase against the overall valuation of their portfolio. Investors might also calculate their average portfolio valuation on a regular basis to compare it to relevant historical benchmark valuations.

Valuations can be subjective, so it’s important to also consider other factors that can make an impact, such as interest rates. Being mindful of valuation when it comes to investment decisions is a vital step in helping to manage both the risk and return of a portfolio.

Do you have an opinion that you want to share with other members of the financial planning community? We encourage financial professionals to send us their ideas for a Your Take column to us at [email protected].