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Assessing US equity valuations

Assessing US equity valuations

Investors focus on equity valuations as one of many tools to form opinion about the timing to take or to continue holding market exposure.

Equity valuations is a multi-dimensional subject, considering various issues in essence around the organic growth outlook and risk factors affecting the price of a business.

An appropriate way to judge overall US equity valuations is to consider S&P 500 index data in this context.

Profitability and outlook

The US and global economic outlook are in the process of moderating, but remain constructive despite the uncertainties around trade tariffs and the (long) duration of the current upswing.

Despite some general concerns about the latter, there is little information in the absolute length of an economic cycle – it is more about potential real or financial imbalances – which are currently not of particular concern.

Key Points

  • Some observers have concerns about high levels of profitability with US equity valuations
  • One way to consider equity valuations is to bring price volatility into the equation
  • We are currently in the proverbial ‘sweet spot’ for higher equity valuations in the current inflation context

Further to this, the current level of US economic growth above the preceding peak has not yet reached its historic average level. Most leading economic indices are moderating, but remain in expansionary mode.

Some have concerns about the current high level of profitability and expect a process of normality in this context. With the S&P 500 general capacity utilisation on its long-term average and the intense focus on business productivity – supported by the positive effects from technological advances – we believe businesses can maintain relatively good levels of profitability.

Absolute valuation levels

The intrinsic value of any business in essence represents the current value of all future proceeds.

This is clearly subject to numerous projections and personal views. The consolidated analyst consensus target valuation upside for the S&P 500 index constituents currently amounts to plus 10 per cent – not implying this may materialise anytime soon.

Many investors prefer earnings valuations in decision-making. Considering data since 1990, the S&P 500 is currently valued at an 18.8 price-earnings multiple, slightly lower than its average of 19.6 times.

In terms of 12-month earnings expectations, the index is currently trading in line with its forward price-earnings average of 17.2 times.

 

Both the free cash flow and dividend yields are moderately lower than their respective average levels (4.6 per cent vs 4.9 per cent and 1.9 per cent vs 2.1 per cent respectively). The dividend cover of 2.3 times in this context is also on its average level.

The current enterprise valuation/earnings before interest, taxes, depreciation, and amortization valuation of 13.1 is well above the average of 10.6 times.

Countering this, the total debt/EBITDA ratio of 4.2 is lower than the average level of 4.6 times, reflecting a higher than average profitability to debt level (without recognising the cash holdings). The current low interest rate environment clearly is a critical positive factor in this context.

Relative valuation levels

Valuations also have to be considered in the context of broader economic factors. The absolute level of interest rates plays a major role in this context.

The equity risk premium (the earnings yield minus the government bond yield) is currently plus 3.2 per cent – one standard deviation above its long-term average.