One of the rules of security valuations is that when you identify an investment with an expected rate of return that’s higher than the market required rate of return, buy it, because the investment is undervalued. Apparently, the recent slump in equity markets has resulted in an avalanche of attractive stock price valuations. But are they really so?
More and more voices on both Wall Street and Bay Street agree that many stock valuations seem deceptively far too low. Why? Simply, when applying asset valuation models, many analysts are not properly forecasting the present values of future cash flows, or rather, the lack of those same cash flows thereof.
Investors and analysts alike are very much aware of the credit problem south of the border. However, what no one knows for sure is just how big this bubble is and how many more “writedowns” are we going to be hearing about in the months to come. To illustrate, while Wells Fargo & Company (NYSE/WFC) managed mostly to keep its name out of the credit crunch sewage, it finally succumbed last week, having to ‘fess up to $1.4 billion lost in bad mortgage and home equity loans.
Of course, as the business cycle turns for the worse, equity prices plunge, while the bond market appreciates. Traditionally, such an investment environment is highly conducive to bargain hunting in the stock markets. However, not properly forecasting the present value of future cash flows could be making currently attractive price-to-earnings (P/E) ratios highly suspect.
To give you an idea, the S&P 500 12-month P/E ratio has slipped to just under 18 times, while the S&P/TSX Composite P/E ratio is hovering around a multiple of 18.5 times, a far cry from a multiple of over 20 reported at the end of October. Granted, these multiples are keeping within historical ranges. However, in comparison to plunging bond yields, stock market multiples appear more and more attractive with each trading session.
Now, I’m not saying that investors should completely avoid stock markets and categorically write off discounted equities from their portfolios. What I am trying to say, however, is to be careful of earnings multiples for they could be based on inflated and unrealistic earnings numbers.
In other words, do your homework. Don’t just look at the income statement, but start paying more attention to the cash flow statement. While a company’s earnings can be manipulated through quite legal accounting measures, the statement of cash flows more or less paints the correct picture about a company. It tells you how much money went in and how much of it went out and what the bottom line is based on.
There is also a way to compare the income statement with cash flows statement to see which items on the former are cash based and which are not. This may require an effort on the part of your investment advisor, but that’s why you are paying him or her the big bucks, isn’t it?