Valuation techniques are critical for analyzing and assessing the levels of investment risk, but they are ineffective as market-timing tools. Why?
It is incontrovertible that the stock price and business value of a company tend to converge over time. The collective business value of all companies making up the stock market has been accurately reflected in the progress of the stock market in the long run. The historical return of the stock market since 1926 has tracked underlying business results of corporate America remarkably well.
The long-term average return-on-equity of corporate America is around 10-12%. U.S. corporations on average have paid out around 50% of their earnings as dividends and reinvested the remainder into their businesses for growth. As a result, companies have grown their earnings by around 5-6% per year. This, together with the long-term average annual dividend yield for the market and price-earnings multiple expansion, result in the roughly 10% compounded annual total return that the stock market has generated over the long run.
When the stock price of a company is higher than its business value, there is the risk of depreciation as the stock price drops to meet the lower business value over time; alternatively, the stock price might stagnate while the business value catches up. Conversely, when the business value exceeds the stock price, there is potential for capital appreciation as market price moves up to converge with business value, at the same time mitigating the risk of a persistent decline in the stock price. In this way, valuation is a very powerful tool for evaluating and managing risk.
On the other hand, it tells us very little about when price-value convergence will occur, and therefore is fairly useless as a timing tool. That is why we often see overvalued stocks march relentlessly higher for awhile, while undervalued stocks can languish for a frustratingly long period of time. This is especially prevalent during speculative “go-go” markets. How long it takes for price and value to converge in a particular situation depends on a complex list of factors, including confidence levels, investor psychology, emergence of high-profile catalysts that capture the fancy of the investment public etc.
Despite the impotence of valuation techniques as a timing tool, they nevertheless represent an invaluable way for properly assessing long-term investment risk.