Are Stocks Getting Too Expensive?

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With the TSX composite index down 10% from its 2011 peak – and still 15% lower than its pre-financial crisis high in 2008 – Canadian investors may be forgiven for wondering what the fuss overvaluation is all about south of the border.

In the U.S., equity markets have been on a rather different ride than the one we’ve been experiencing here in Canada. As I write these words, the S&P 500 is about 15% above its 2011 peak, and almost 30% higher than it was at the start of 2011. To put it another way, U.S. investors who stayed in the market through the crisis are now officially back to where they were in 2008.

All of this recovery has led to the usual warning cries that we may be in a stock market bubble. Now, I’ve never been one to advocate making short-term calls when it comes to the market. But all this talk about systemic overvaluation this early in the recovery strikes me as a little silly, even by the most aggressive of market-timing standards.

According to iShares, U.S. stocks today are trading at about 2.25 times book value. To put that into perspective, in 2007, shares of U.S. stocks were trading at about 3 times book value. In 2000, stocks were trading at about 5 times book value.

Perhaps more importantly, the trailing Price-Earnings (P/E) Ratio of the U.S. market is also currently standing at 15, which is similarly well below the historical average of 16.5. It’s one thing to be below historical averages when interest rates are at an average level. But it’s a whole other kettle of fish to be below the average when interest rates are at 150-year lows.

Why? Well, for one thing, when you invest, you’re essentially making a choice about where to put your money. You can invest in a stock like the Bank of Montreal, which is sporting an attractive dividend of around 4.6% (plus the probability of long-term capital appreciation). Or you can buy a 5-year GIC from the same bank – which will pay you about 1.95% a year.

This equation looks a little different when you’re choosing between a stock with a 2% dividend and a GIC that’s paying, say, 5% or 6%. Trading in a higher immediate payoff for possible future growth is a tough call to make. But when one of your options offers both long-term growth AND a higher income? Suddenly, the decision becomes a whole lot easier.

The fact is, relative to interest rates, stocks have never been cheaper than they are today. And corporate balance sheets are also bulging with more cash than they’ve seen in most investors’ lifetimes.

If you take that cash out of the equation, you get an even more attractive multiple of the actual business operations. Sure, some of the diehard bears out there might argue that you shouldn’t take cash off the balance sheet when you’re calculating multiples. But it seems to me that if I were selling a business that had a huge pile of cash in the bank, I’d be selling the business – not the bank account.

Take Cisco Systems as an example. Cisco’s current Price-Earnings (P/E) Ratio is about 11. Credit Suisse estimates that Cisco’s 2013 earnings will come in at around $1.99 per share. This gives them a forward-looking P/E Ratio of about 9.5.

If you ask me, that’s a pretty good valuation. Another way to look at P/E Ratios is how many dollars of corporate earnings you get for every $100 of capital you invest. In the case of Cisco’s 9.5 P/E Ratio, you’re getting close to $10 in earnings for every $100 invested. Not bad, compared to a GIC that’ll pay you $2 on the same $100.

But the story for stocks doesn’t end there. Cisco has $32.5 billion (yes, that’s billion) in cash sitting on its balance sheet. Divided by the number of outstanding shares, that works out to about $6 of cash per share. The company’s current stock price is around $21, so if we took that $6 cash per share out of the equation, the company’s actual operations are being valued at $15. A $15 stock with $1.99 of earnings would be trading at a P/E Ratio of about 7.5.

When stocks are trading at all-time lows relative to interest rates, and they’re below the 16.5 historical P/E average, AND companies like Cisco are sitting on piles of cash – well, you can draw your own conclusions. But it seems to me like an odd time to be talking about a stock market bubble.

We can all be forgiven being a little gun-shy. The markets haven’t been kind for a long time, and the decision to put your hard-earned money back into stocks can be more than a little unsettling if you’re looking backwards.

Looking forward, however, it seems like a pretty straightforward decision to me.

Alan MacDonald, an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.

For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.

All material has been prepared by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

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