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Ask the investment professionals: What valuation metrics do you monitor and how should investors use them?

Submitted by Brian.Lavelle on September 9, 2019

Charles Schwab & Co. Chief Investment Strategist Liz Ann Sonders says popular measures of market valuations are better for some uses than others.


GRAPHIC: [Ask the investment professionals]

GRAPHIC: [What valuation metrics do you monitor and how should investors use them?]

LIZ ANN: So I not only look at all the PE ratios, everything from forward to trailing, five-year normalized, which is four-and-a-half years back, two quarters forward, and actually takes the blend between reported and operating earnings, which I think is an interesting way of doing it. You know, Schiller's cyclically-adjusted PE, which is a 10-year look back, but I also look at equity risk premiums and the Fed model and the Rule of 20, and Tobin's Q [Ratio], and market cap to GDP or GNP—which is the Buffett model—and I keep a table that you've seen, Mark, and it will raise the table based on whether the metric says the market is undervalued or overvalued, and it literally runs the gamut. So I could find the most bearish person in the room and the most bullish in the room, and hand you a valuation metric and say, 'Here, you can prove your point with this.' Because those valuation metrics that do take inflation [and] interest rates into account, it looks at, you know, through a filter, say the market is actually still pretty reasonably valued, things like equity risk premiums, and Rule of 20, and Fed model. Those are the more longer-term in nature and look back—Schiller Cape and the Buffett Model—say the market is egregiously overvalued.

Traditional P/Es, a couple points on those, they should never be used as a market timing tool. I have scatter-grams for forward P/E, trailing P/E, as to how predictive the level of the PE is for subsequent one-year return in the market, and it's actually a slight negative correlation. Over any reasonably long period of time, things like Schiller Cape can be a good proxy for whether you're likely to see better than average or worse than average kind of 10-year returns, so I think they're valuable there.

But, frankly, you know, we think of P/E as this quantifiable fundamental indicator. We know what the price is, we know what the E is, those are two quantifiable factors, therefore, it's a fundamental factor. But it's as much a sentiment indicator as anything else. There's just going to be times, like the late 90s, that investors are willing to pay nosebleed valuations, and a period like 2009, where investors don't want to touch stocks no matter how cheap they are.

GRAPHIC: [Own your tomorrow]

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