Are Stocks Overpriced--or the Yardsticks Flawed?

Commentary

Are Stocks Overpriced--or the Yardsticks Flawed?

By Jeffrey M. Laderman
Business Week

July 15, 1996

If you look at conventional stock market ratios and listen to the gurus who follow them, stocks are about to tumble into the abyss. The market's price-earnings ratio is above its long-term average; the dividend yield, well below. Then there's the "Q ratio," which compares corporations' market value with the replacement cost of their physical and financial assets. The Q ratio says the market is 70% overpriced. Conclusions: If you own stocks, get out. If you're thinking of investing, wait.

It's tempting to latch on to such pronouncements, especially since stocks have risen more than 50% in the past 20 months. And these indicators distill a lot of data into easily digestible capsules. But wait: As predictors, they're seriously flawed. Relying on them is akin to driving with your eyes fixed on the rearview mirror.

The indicator generating the most interest these days is the Q. This ratio, developed three decades ago by James Tobin, 1981 Nobel laureate in economics, compares the total market value of the nation's stocks and bonds with what it would cost to replace all the corporations' assets. When the ratio is below 1.0, stocks are a buy, because it's cheaper to buy businesses than build them. But when the ratio is above 1.0--and it's now a historically high 1.7--stocks are overpriced. It's cheaper to build than buy.

Intangibles. The problem is that the Q belongs more to the manufacturing economy of the 1960s than the service and information economy of today. Back then, the value of a company was largely its tangible assets, such as plant and equipment. Today, intangibles--human capital and brand names--count for a lot more. Take Microsoft Corp. Most of its value lies in its software products, its programmers, and its lead position in desktop computing, not in factories or offices. The stock, now at $121, sells at nearly 11 times book value, which is reasonably close to the replacement cost of its tangible assets. So using a Q analysis, Microsoft would be worth only $11 a share.

Even when it comes to industrial companies, the Q misses the mark. "There's investment in computer software and worker training, which increase productivity but are expensed and don't show up on the balance sheet,'' says Abby Joseph Cohen, an investment strategist at Goldman, Sachs & Co. "Just because things don't fit nicely into our accounting system doesn't mean they don't exist."

At first glance, the p-e ratio also suggests that the market is overvalued. The Standard & Poor's 500-stock index, now at 674, divided by the current year's forecast earnings, about $40, gives an overall p-e of 16.9. But the average for the 1950-95 period is 14: Ergo, the market is overpriced--by 20%.

But averages can be misleading: They work only in an "average" environment. Actually, the market is enjoying a better-than-average backdrop of moderate growth and low inflation. According to Goldman Sachs figures, p-e ratios have, since 1950, averaged 16.2 during periods when inflation was below 3.5%.

More important, earnings growth is well above the long-term norm. From 1945 to 1995, S&P 500 earnings grew at 7.4% a year--or 3.1% after inflation. In the '90s, earnings growth is 9.7%--a striking 6.3% after inflation. Plus, the quality of earnings is better. Managements are more focused and are running leaner operations. Think of today's overall market as a high-quality growth stock. It deserves a higher-than-average p-e.

Not Fail-Safe. Perhaps most irrelevant of the valuation indicators is the S&P dividend yield. The old saw: Stocks are overvalued when the yield falls below 3%. Well, that happened 4 1/2 years ago--and the market is up by more than 60% since. Why don't dividends matter anymore?

Dividends are an inefficient way to reward shareholders. Tax rates are as high as 39.6%, and taxes are inescapable. Many companies prefer share repurchases. That usually boosts the stock, and the only investors who get hit with taxes are those who sell. Even then, they pay at the favorable capital-gains rate.

The fact that shareholders are ignoring dividends is not a cause for concern. It's a vote of confidence that corporate managements will use their cash to better purposes--buying in shares, paying down debt, or expanding the business.

Because these measures aren't appropriate for this market doesn't mean stocks won't sell off. A recession or an external shock, such as the fall of the Saudi ruling family, would send stocks reeling. But in such cases, you wouldn't get any advanced warning from the Q, the p-e, or dividend yields.