How Do You Solve The Problem of Valuation ? How Do You Catch A Cloud And Pin It Down ?

There has been some debate on stock valuations with banks naturally bullish (for the companies are their clients) and independent observers locking horns most recently on the CAPE methodology.

CAPE stands for Cyclically Adjusted P/E which is coined by none other than Robert Shiller of the Case Shiller Index fame.

Arguments for Over Valuation

This diagram taken from a guest post in Zerohedge suggests that when profits revert to their mean, valuations would correct.


That is because the outlook is a trite too overly optimistic at the moment and only made possible in the QE years on cheap funding which has led to a surge in corporate earnings in the absence of revenue growth.

Taken from another Zerohedge guest post.

“Since 2009 the reported earnings per share of corporations, the bottom line of the income statement, have increased by a total of 222% which is the sharpest, post-recession, increase in reported EPS in history.  However, at the same time, reported sales per share, which is what happens at the top line of the income statement, has only increased by a marginal  22% during the same period. ”
“In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons:  wage reduction, productivity increases, labor suppression and stock buybacks.  The problem is that each of these tools create a mirage of corporate profitability.  The problem, however, is that each of these not only have a negative economic consequence but also suffer from diminishing rates of return over time.
One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buy backs.”


For the past months, I have been asking friends and experts what is a typical P/E we would use for a slow growth recovery and answers have been vague. Most just point me to the Nikkei lost years and told me to use those.

Zico has been more dismissive, saying that I should not even bother with P/E as he does not buy the diversified stock portfolio strategy idea.

I am no expert but have been pretty bearish and wrong in the past months. Not to say I have not bought any stocks for I was bullish Google and Nokia, for small gains.
4. Equities

My equity strategy will have to change next year. I have mixed feelings about equity especially in times of austerity. Companies are cutting back on R&D and technology upgrades and spending on stock buy backs.

So short term trades for me in general stock indices and again will invest time in sniffing out the companies with intellectual know hows that will pave the way into the future.

I had small gains in Nokia and RIM this year and Facebook too !! But next year will be a year of Chips and Clouds. Am watching Intel, Google and ARM.”

Yet the issue of valuations are now getting to me.

Linked In is one of the companies that is difficult to value, much like Facebook. They are cashing out with another billion dollar in stock offering and the insiders are getting out too.

We know how these things work by now. We have the lead manager who supports the price, wait for the public to come in and then they go away like they did for Facebook last year.

I have always approached valuation from 3 angles. 1. future earnings,  2. benchmark against risk free rate and, 3. financial strength i.e. net asset value. So you can see, Linked In is quite a dilemma and more of a “hype trading” play for me.

Errr, did I tell anyone about Inovia US 3 weeks ago ? A pure punt, of course.

The future of companies is that we will have much less cash for stock buy backs when the easy funding life line is taken back. Valuations will be increasingly important but increasingly elusive for us to pin down.

Is that not a perfect storm lying ahead ?