Further Upside to Valuations
- Valuations Up 55% in Past Five Years…Five Reasons They Should Go Even Higher:
- S&P 500 multiples are up 55% over the past five years, increasing from 10.5x to 16.2x today. Not surprisingly, many investors now question the sustainability of P/Es. Below are five reasons we believe they should drift higher:
1. Cash Flow Generation: Companies are generating 20%+ more free cash flow from every dollar of earnings (FCF conversion). This should push P/Es commensurately higher.
2. Return of Capital: The Total Yield (dividends + buybacks) of the S&P 500 is 4.7% versus 4.4% for a 20-year corporate bond. Stocks are extremely undervalued on this and other relative yield metrics. Further, the return of capital is 100% covered by free cash flow.
3. Volatility: Realized and implied volatility have been running ~30% below normal. This should equate to a similar reduction in equity risk premia.
4. Valuation Trends: Equity valuations tend to move from low to high (and back) over very long periods, similar to a slow-moving pendulum. With multiples well within a normal band, the current swing higher appears far from over. (See Exhibit 1 below.)
5. Few Excesses: Stocks are most likely to correct when some group is unreasonably priced. With the exception of Energy, whose multiples are elevated due to falling oil prices, there appear to be few excesses (yes, this would include Staples).