Are Stocks Overvalued? A Survey Of Equity Valuation Models

July 28, 2015

It should come as no surprise in one of the longest-running bull markets in U.S. history that the question "Are stocks overvalued?" is ever present in the minds of both investors and investment professionals. A Google search of this simple phrase returns 551,000 results, and an Amazon book search for "equity valuation" finds 3,411 listings. For better or worse, the topic is even periodically broached at the highest levels of the Federal Reserve:

I would highlight that equity market valuations at this point generally are quite high…. They are not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low, but there are potential dangers there.

Federal Reserve Chairperson

Janet Yellen (2015)

[H]ow do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions…?

Former Federal Reserve Chairperson

Alan Greenspan (2008)

An attempt to answer this deceptively simple question is aided by various equity valuation models and tools, all of which can be extraordinarily useful in estimating the expected long-term return of the market. These tools cannot consistently tell us, however, with any accuracy, when market prices will be heading up or down, although they may occasionally get lucky.

Figure 1, which shows a box plot of returns for the S&P 500 Index over different investment horizons, helps explain why this is the case.1 Take, for example, the five-year investment-horizon box. It shows the historical distribution of annualized returns for every five-year period in the history of the S&P 500. Notice that as the investment horizon increases from 1 to 10 years, the median return (i.e., the horizontal line across the center of the box) remains pretty stable, while the variance of returns narrows dramatically. Said another way, short-term forecasters must contend with a lot of uncertainty. Of course, given a large enough number of forecasts, based on a sufficiently broad set of indicators, a few short-term forecasts will eventually hit the mark, but in general, it's a losing game. Thus, for those engaged in short-term forecasting, we can only say, "Good luck with that!"

We do not mean to imply that equity market valuation is a hopeless endeavor. On the contrary, over the long run it can be of enormous benefit to the patient investor. Just as with valuing individual companies, the tools we use to value entire stock markets fall into two categories. The first includes absolute valuation models that directly estimate expected returns by using an approximation of discounted cash flows condensed into a building-block type of model, such as the Gordon growth model.2 The second category includes relative valuation models based on price multiples that are compared against a steady-state level. Although we could write reams discussing every model and ratio that has ever been documented on equity valuation, we restrict our focus to the more popular metrics.

We use real returns in our analysis because returns after inflation are what build wealth.

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