Forget Everything You Know About Valuing Companies

Forget Everything You Know About Valuing Companies
Andrew Rummer

over 2 years ago4 mins

  • A new study proposes overturning the capital asset pricing model that’s been at the heart of most investment decisions for decades.

  • By taking better account of factors like depreciation, inflation, and central bank bond purchases this new valuation model reckons US stocks don’t look as overpriced as lots of investors think.

  • But watch out for climbing bond yields, a big move in inflation, or companies struggling to maintain profit margins as signs of trouble.

A new study proposes overturning the capital asset pricing model that’s been at the heart of most investment decisions for decades.

By taking better account of factors like depreciation, inflation, and central bank bond purchases this new valuation model reckons US stocks don’t look as overpriced as lots of investors think.

But watch out for climbing bond yields, a big move in inflation, or companies struggling to maintain profit margins as signs of trouble.

Mentioned in story

A good valuation is at the heart of every smart investment, and investors have been calculating them for decades by relying on a well-worn formula known as the capital asset pricing model (CAPM). Now, though, new research wants to replace CAPM with a whole new framework – potentially changing the way you invest for good.

How does CAPM work?

Put briefly (you can go much deeper in our Pack, The Tricks And Techniques You Need To Value Stocks), CAPM allows you to estimate how much a company’s future profit should be worth to you today. You calculate it by plugging in three things: the return you’d get from a theoretically risk-free investment (namely US government bonds), the “risk premium” (the amount you get paid for taking the risk of buying a stock over that risk-free investment), and “beta” (a measure of how much a single stock swings about in relation to the entire market).

CAPM formula

That formula produces a “discount rate” that then allows you to estimate the value of a stock in conjunction with the stock’s own metrics, like this:

Discounted cash flow formula

What’s wrong with CAPM?

A new report from the US consulting firm Oliver Wyman argues that CAPM has some major flaws and proposes a replacement it calls the “Holistic Market Model”. It’s a massive, multi-part document, but two conclusions jump out as hugely relevant to anyone investing in stocks. 

Firstly, Oliver Wyman wants us to reexamine how we define the very concept of profit – central to any attempt to value a company’s shares.

It argues that the way companies report profits under so-called “generally accepted accounting principles” (GAAP) underplays the role of inflation. In times of high inflation, the depreciation calculations used in GAAP earnings will understate how much companies need to spend just to keep business ticking over, and overstate it in times of low inflation. But it’s these GAAP earnings that economist Robert Shiller used to calculate his famous valuation method, the cyclically adjusted price-to-earnings (CAPE) ratio – a calculation most investors emulate.

Instead, Oliver Wyman argues that investors should copy legendary investor Warren Buffett: look at the surplus profit a company generates after accounting for the reinvestments it needs to continue operations. This measure – which they call “Buffett earnings” – suggests profits generated by US companies were less impressive during the high-inflation period from the Second World War to the 1980s, and more impressive in the inflation-tamed period since.

Valuation chart with Buffett earnings

And here’s the good news: when you plug these Buffett earnings (black line) into a valuation chart for US stocks next to the GAAP earnings (green line), you see that stocks look a little less expensive by historical standards.

Valuation chart with Buffett earnings

The second major tweak that this new Holistic Market Model proposes concerns the “risk-free rate” that’s at the heart of the traditional CAPM valuation model.

CAPM uses the yield on US government bonds – a.k.a. Treasuries – as a proxy for risk-free returns. But Oliver Wyman doesn’t think this does enough to account for the way bond prices move with inflation expectations, nor other factors like central bank purchases and demand from foreign governments. Subtracting these vagaries from the Treasury yield then produces what Oliver Wyman calls the “really truly risk-free rate,” or RTRR. 

Adding the risk premium onto this RTRR instead of the sort-of-but-not-really risk-free rate gives a more accurate estimate of stock market valuation, Oliver Wyman argues. Hence its model (the black line in the chart below) better fits the price investors have been historically willing to pay for stocks (in green) than the older model (in blue). 

Valuation chart versus Fed model

Why should you care?

This is all rather academic so far, I know. But there is a point to all this modelling. 

By using Buffett earnings and the RTRR, Oliver Wyman reckons there are rational reasons why investors are so willing to pay such high sums for US stocks at the moment. That should ultimately give us all more faith in the fundamentals underpinning the current bull market. 

But Oliver Wyman’s analysis does suggest there are new risks – those perhaps less applicable to the CAPM model – that could bring the stock market rally to an end. Reading between the lines, prices could start to fall if:

  • The RTRR rises from its current extreme low, meaning investors would be able to get reasonable returns from safer assets like government bonds.
  • Inflation breaks out of the moderate “Goldilocks zone” it’s occupied for the past few decades, either upwards into more sustained inflation or downwards into full-on deflation.
  • Buffett earnings pull back from their current high levels – because, say, companies fail to maintain their profit margins, or governments raise taxes on them.

Ultimately, the Holistic Market Model has a lot to recommend it, and the numbers it presents suggest it gives a better estimate of whether stocks are over or undervalued. And while CAPM has been the bedrock of stock valuation for at least 60 years, it’s possible this new iteration will dominate asset allocation decisions in decades to come.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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