When Will S&P 500 Valuations Matter Again?

In the private markets, buyers and sellers care a great deal about valuation. For example, a financial advisory practice might fetch between 1 percent and 2 percent of assets under management. Or it might go for 2.3 times trailing 12 months’ gross revenues. Higher or lower valuations depend largely on things like key personnel, average account size, client retention, economies of scale and the growth rate.

The critical importance of valuation also comes to light on the popular television show, “Shark Tank.” Having already placed a value on their respective companies, entrepreneurs approach business titans to pitch their products and services. An entrepreneur may want $500,000 for a 25% stake, implying that he/she believes that the company is worth $2 million. Personalities like Mark Cuban and Kevin O’Leary (a.k.a. “sharks”) might not agree. Perhaps one of them might offer $325,000 for a 50% stake, placing the value at $650,000.

In the public marketplace, buyers should care about the price they are paying for S&P 500 corporations. At this moment in time, though, they care little about the price they are paying.

On virtually any methodology one employs, the U.S. stock market is extremely overpriced. Other than the tech bubble’s brief insanity in early 2000, one would be hard-pressed to find circumstances when stock prices were more euphoric than right now in 2018.

In fact, there are other measures that show that the market is every bit as bad as it was in 2000. For instance, Geoffrey Caveney demonstrated that the median price-to-free-cash-flow (P/FCF) for the S&P 500 SPDR Trust (SPY) is roughly 35. That means investors who acquire U.S. stocks at present-day prices are accepting the market at approximately 35 years worth of free cash flow.

Corporations may be able to manipulate bottom-line earnings results, but they cannot feign an ability to generate cash. It follows that a P/FCF ratio of 35 shows that the S&P 500 is trading at exorbitant levels not unlike the tech bubble in 2000; specifically, S&P 500 companies in aggregate are not generating enough free cash flow to support the multiple.