Thursday, May 24, 2012

Large Cap Valuations

A little less than ten years ago, with the S&P 500 was down nearly 50% from its highs and was hitting the lows of the bear market.
(The NASDAQ dropped more like ~80%.)

At that 2002 bottom for the S&P 500, here are some examples of market valuations for certain large cap stocks:

Microsoft (MSFT)*
Price Per Share: $ 23.19
Earnings Per Share: .70
P/E: 33x

Wal-Mart (WMT)
Price Per Share: $ 51.64
Earnings Per Share: 1.81
P/E: 29x

Johnson & Johnson (JNJ)
Price Per Share: $ 56.80
Earnings Per Share: 2.16
P/E: 26x
Coca-Cola (KO)
Price Per Share: $ 51.46
Earnings Per Share: 1.60
P/E: 32x

So high valuations persisted even at the very bottom of a bear market. I could have used other examples but chose stocks with relatively stable earnings so the high multiples would not be a reflection of cyclical lows in earnings power.

Well, these days the market is obviously no where near the lows of 2009 for the stock market but, and this probably won't come as a surprise, check out the valuations relative to current consensus earnings estimates for the same stocks.

Microsoft
Price Per Share: $ 29.11
Earnings Per Share: 2.72
P/E: 11x

Wal-Mart
Price Per Share: $ 64.58
Earnings Per Share: 4.91
P/E: 13x

Johnson & Johnson
Price Per Share: $ 62.66
Earnings Per Share: 5.12
P/E: 12x

Coca-Cola
Price Per Share: $ 74.55
Earnings Per Share: 4.09
P/E: 18x

Not surprisingly, even if purchased at the market bottom in 2002, none of these stocks produced spectacular 10-year returns.

The reason seems clear enough. They were simply still too expensive even at the 2002 market bottom to make good returns. Their business prospects were just fine and lots of intrinsic value was created but long-term investors had very little to show for it because of the price paid.

Some may say if the multiples continue to contract returns will continue to be subpar. While that's certainly true in the near term or maybe even intermediate term, the contraction only delays and, in fact, enhances the long-term returns (by allowing shares to be bought back below intrinsic value).

So if you are trading with shorter term outcomes in mind this clearly is a real problem.

On the other hand, if you are investing and have a longer time horizon it is anything but a problem.

Look to something like Altria (MO) for an example of a stock that outperformed** since the 2002 lows (substantially...it's up ~ 6-fold including dividends).

It did so not because the business itself did so much better than the others (each of these quality franchises had, give or take, solid decades of business performance).

Instead, Altria outperformed for the straightforward reason that it was selling at a single digit multiple of earnings back then while the others were not (MO now sells at a multiple in the mid-to-low teens).

This doesn't necessarily mean any of these stocks make sense to buy***, but it is a reminder just how different the valuation environment is these days for quality large capitalization businesses.

Adam

Long all the stocks mentioned at much lower than recent market prices

* When you subtract Microsoft's net cash and investments per share its multiple drops to more like a bit over 8x.
** Returns depend on what owners did with the Kraft (KFTand Philip Morris International (PM) Spin-offs.
*** Coca-Cola may sell at a lower multiple than 10 years ago, but it is still not all that inexpensive near current prices. Wal-Mart's has rallied quite a lot lately even if the earnings multiple remains in the low teens.
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