The U.S. market has gotten much more expensive in the past five years following the incredible buying opportunity in 2009. One great valuation measure is EBITDA (earnings before interest, depreciation, and amortization) divided by Enterprise Value (sometimes called ‘takeover value’, calculated as market value of a company, plus debt, minus cash). I’ll shorten the name and call it ‘EBITDA yield,’ a higher yield means the market is cheaper.
Using this measure to look at all investable stocks in the U.S.[i], it’s clear that the market as a whole has gotten more expensive since 2009. The EBITDA yield at the end of February, 2009 was roughly 14% for the entire U.S. market—today it is 9%. But the market’s overall valuation only tells part of the story. The market in 2009 offered a wide variety of valuations, whereas today, in 2014, the opportunities are much more clustered. Stocks today are more expensive, but valuations are also much more homogeneous. Here is a look at U.S. stocks[ii] and how their valuations were dispersed in 2009 and 2014, compared to their very long term average.
This change is being driven by a convergence of valuations. In 2009 cheap stocks were very cheap; now, they are less so (blue line below). The EBITDA yield for the cheapest stocks (10th percentile) has come down dramatically, from 35% in 2009 to 17% today. In contrast, expensive stocks (90th percentile) are about as expensive today as they were in 2009 (red line below). The market median (green line below) has also gotten more expensive-mainly because the cheaper stocks have done so well. This is driving the clustered valuations we are seeing today. Fewer big bargains have led to a more uniform market.
This doesn’t suggest that you should abandon valuation as a key component in stock selection (quite the contrary), but it does suggest there is less of an edge today in cheap stocks than there was five years ago: there are far fewer U.S. stocks that are very cheap. International markets offer more diverse valuations (see Meb Faber’s CAPE calculations for countries), but that is a topic for a different post.
[i] Market Cap> $200MM
[ii] Stocks with market caps>$200MM inflation adjusted
Of course 2009 offered a wide variety of valuation, but astute investors shouldn’t wait for 10-standard-deviation events before deploying capital. Also, why do you use only 500 stocks as representative of the U.S. stock market. More troublesome even is including only those "with market caps > average" - what does that even mean?
I didn’t argue that investors should wait for 10-standard deviation events. Stocks greater than universe average is just a clean way of building a large stock universe similar to the S&P 500 that scales well through time. Just inflation adjusting a floor (say $10B) doesn’t work that well because equity markets grow so much faster than inflation.
First, I appreciate you taking the time to reply!
I don’t see why this approach (EBITDA/Enterprise Value) requires any major adjustments. I wonder why inflation should be a concern here as the numerator/denominator are both subject to the same inflationary effects; therefore, yield should be comparable across time. Also, why not track yields of all stocks on the Wilshire 5000 over time - this would be much more representative of all U.S. listed stocks?
You deny arguing that investors should wait for 10-standard deviation events, yet the focus of the article is on 2009 as a comparison - how is this helpful? A return to these types of valuations is not likely to happen very often - yet, I’m positive one can still find tremendous opportunities today. Admittedly, there is less of an edge today compared to 2009 (obviously), but there is always an edge when investing rationally.
Finally, a look to yields without addressing expectations is a bit concerning. Is it possible investors are factoring higher earnings in the future, thus willing to pay up for earnings today, driving yields lower? This seems to be a major consideration that is left out of your analysis.
Sorry, I’m not being clear enough. EBITDA/EV isn’t adjusted at all. I mention inflation only as a way to scale the market cap floor that I set for my universe (which I think of as the "investable" universe), maybe a product of my day job as an asset manager, where we can’t really invest in many micro caps easily without bid/ask spreads ruining our advantage (although some we can).
Also, you found an error which I’ll correct, the two charts in this piece are on "all stocks" with market caps>200M inflation adjusted, not "large stocks" with market caps greater than average. I originally ran on large stocks as a sort proxy for the S&P 500 and posted that chart to twitter (which you can find on my twitter feed), but changed to all stocks to be more inclusive for this post. No adjustments are made to EBITDA or EV because, as you point out, its a ratio so it doesn’t matter.
As for your other comments, this piece was intended to point out how valuations have changed since the 2009 bottom-but it was not meant as investment advice of any kind. I agree there is always a market edge with the right strategy and the right discipline.
I can’t speculate on what is driving these changes in yield/valuation. The fact is, when stocks as a whole or on the individual level are cheaper, they tend to deliver better future returns. The market tends to over-extrapolate recent conditions, one of which is very high earnings/margins right now. That gives me pause, and makes me believe even more than focusing on cheaper/lower expectations stocks is key in this environment.
Hope this helps,
Patrick