Are equity markets expensive? How we assess valuations

Shaun Port

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A critical part of investing is understanding how different asset classes, markets and sectors are valued. Here, you’ll find out how the Nutmeg investment team approaches valuations and why we think they’re important.


Why valuations are important

Understanding valuations plays an important part in Nutmeg’s investment strategy. While valuations don’t have a very significant predictive power of returns over the short term, they are an important guide to the future long-term performance of asset classes and also the relative attractiveness of different asset classes or markets.

How we assess equity market valuations

A common measure often talked about is the price-to-earnings ratio. The price-to-earnings ratio shows the price of all stocks in a market or index (like the FTSE 100) relative to their total earnings over the past year.

For the US market, the S&P 500 is the main index of the top 500 stocks. The ratio for the S&P 500 shows the composite price for these companies (the index value) divided by their earnings (weighted by their size in the index). As the chart below shows, at 25 times’ earnings over the past year, the US market looks somewhat expensive versus the very long history, albeit cheaper than in the early 2000s. But, this measure is just one of many that can be used to assess valuation, and it’s important to bear in mind that it’s backward-looking.

Source: Macrobond

To provide a consistent assessment across a very broad range of countries – 47 in fact – we use a comprehensive dataset from MSCI, a leading provider of company data and analytics. This means we can use a range of measures, both backward- and forward-looking.

We use three backward-looking metrics: the price-to-earnings ratio, the price-to-book value and the dividend yield. The book value represents the accounting value of assets, while the dividend yield is the amount of dividends paid out by companies over the past year. The forward metric used is the price to expected (consensus) earnings over the next 12 months. Backward measures tend to have the longest history, but naturally fail to incorporate expectations for growth in the future – one of the most important factors in financial markets. While a stock market may be rising strongly, if expectations of future earnings are rising faster, then the market is in fact becoming cheaper.

For each country, we measure the current level of each metric against its long-run historic average over at least 25 years and the deviation from average. This produces a ‘normalised’ value, also known as a Z-score. Using the Z-score for each measure we can combine them to produce a composite valuation score for each country relative to its own history. We believe this is a more accurate way of comparing valuations across countries, given the many differences across countries such as economic structure and accounting.

The results

Below is the range of measures for 47 countries within the MSCI global dataset, with Z-scores and a composite value for each country. 0 represents the average, +/-1 is expensive/cheap and +2/-2 very expensive/cheap.

We can see that global developed equity markets have a +0.12 composite score, close to zero – in other words about averagely valued. On the forward measure, equities are slightly cheap and on the backward measure, slightly expensive. Excluding the US, which is slightly expensive, global developed equites are reasonably cheap across all measures (composite Z-score -0.50), as are emerging markets.

Across different countries, New Zealand and India stand out as being expensive, while Singapore, South Korea and Japan have reasonably low valuations. Despite strong performance of equities since the financial crisis, stock markets don’t look badly valued on the whole. In fact, across the 47 countries, 42 are cheaper now than at the end of last year on a forward price-earnings basis, with only a handful of smaller markets now more expensive (Israel, New Zealand, Finland, Taiwan and Qatar).

Source: Nutmeg calculations using data from MSCI, Macrobond.  Long run refers to since 1994 for forward price-earnings, 1975 for trailing price-earnings and 1970 for price-to-book and dividend yield. Data history prior to 2001 is calculated using a combination of the large and mid size company indices.  Z-Scores calculated as the number of standard deviations from the long-run average. The weighted Z-Score is calculated as a 50% weight to the forward p/e Z-score and 50% weight to the average of the three trailing measures.

The Nutmeg view

We’ll continue to monitor the market valuations using this method, but as it stands, we feel the evidence supports our view that equity market returns are likely to continue to be good in the future.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.

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Shaun Port
Shaun is the chief investment officer at Nutmeg. He has over 25 years’ experience developing and implementing investment strategies for clients ranging from central banks to pension schemes to charities and private individuals. Shaun holds a degree in Mathematical Economics from the University of Birmingham and is a Chartered Alternative Investment Analyst. He can be found tweeting @ShaunPort.

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