A primer on stock market valuations: do they matter?
Warren Buffett is one of the best stock market investors of our era, and he is famously quoted to have said:
''Price is what you pay, value is what you get''.
So if one of the best investors out there stresses so much the importance of valuations, they must surely matter.
The same idea is echoed in the famous speech that Sun Microsystems' CEO Scott McNealy gave to his beaten-up investors in 2000 where he said:
''At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes.
What were you thinking buying my stock at 10x sales?''
The chart below seems to confirm the assumptions that valuations matter when it comes to generating long-term returns as well.
It shows a strong correlation between normalized P/Es (x-axis) and subsequent 10-year forward returns (y-axis) in the S&P500: the more expensive your entry valuations, the lower the returns you should expect in the subsequent decade.
Given today's 26x SPX normalized P/E, investors should therefore expect an average 0% return (!) for the next decade.
But is that so simple?
Buying cheap stuff ensures you'll make juicy returns, and vice versa?
Well, it depends from your time horizon.
Research also shows that the entry valuations has a negligible explanatory power for subsequent returns in the next 6-12 months.
In other words, on a shorter time frame cheap stuff can get cheaper and expensive stuff can become more expensive.
Momentum can make the market stay irrational longer than we can stay solvent, and so using valuations to inform your decision-making for ~1 year time horizon is not a great idea.
On the other hand, if you are really a long-term oriented investors valuations do matter for your returns.