Thursday, August 21, 2014

Rethinking Buffett's "favorite" valuation metric

I have written about this topic before (see He who solves this puzzle shall be King), but in his weekly commentary, John Mauldin wrote about developing bubbles. Mauldin referenced the following chart (from Doug Short) of market cap to GDP as Warren Buffett's favorite valuation metric to show that stock market valuations are stretched.

I have called this same indicator as Buffett's favorite valuation metric before. However, I have not seen him publicly reference this ratio in interviews in the last 10 years. I am therefore re-considering the validity of this valuation measure.

The market cap to GDP ratio is really shorthand for an aggregate price to sales ratio. Recall that the price to earnings ratio is price to sales divided by net margin - and corporate net margins have risen considerably over the past few years and created distortions in both the P/E and P/S ratios. This chart from Goldman Sachs (via Business Insider) shows how corporate net margins have reached new highs.

The rapid expansion in net margins suggests that they are at risk of mean reverting and falling at some point in the future. However, analysts like Dan Suzuki of BoAML have shown before that net margins have mainly been rising for financial reasons, namely lower interest expense and lower tax rates, rather than an increase in operating margins (via Business Insider).

So, if P/E = P/S/(Net margins), then how valid is the price to sales metric if net margins are distorted by these factors?

This analysis doesn't mean that equity valuations aren't stretched. I wrote before that stock prices appear to be elevated based on a combination of PE, PB and dividend yield (see More evidence of a low-return equity outlook). However, price to sales may have outlived its usefulness as a valuation metric given the current net margin environment and, by extension, to call market cap to GDP Warren Buffett`s favorite valuation indicator may be a label that`s well past its "best use" date.


Anonymous said...

Given that corporations in the U.S. generates over 40% of their revenue from overseas, shouldn't the metric in comparison be market cap to GNP, not GDP?

Anonymous said...

I can see from your analysis how p over e is affected. But you also said p over s is affected and i still can't figure out why you said that.