What Return to Expect From a Fairly Valued Stock?

Alternative Title: A Common Misconception in Finance

Investors often talk about stocks as being over- and under-valued. 

Quick Quiz: What is the expected future return of a fairly-valued dividend paying stock?

  1. Zero

  2. Positive

  3. Negative

I find that when people refer to a fairly valued investment, they somehow imply that the future return is automatically zero or negative, which is not the case. 

In a Dividend Discount Model (DDM), you need to plug in the discount rate R

Fair Price = Future Dividends / (Discount Rate- Growth)

Hence, the expected return of a fairly valued security is equal to R, a positive number. 

Quiz Answer is #2 - Positive.  

Should investors hold fairly valued securities in their portfolios? The knee jerk answer is “no”. But what is so wrong about earning average expected equity returns?

Active managers try to find under-valued securities and outperform the market, which for the most part, does not work. But for most investors, earning equity averages by investing in fairly valued securities is a great long-run outcome, if they actually manage to hold on to these investments. 

What happens when securities become over-valued? Does it automatically imply a negative future return? No. A lot of over-valued securities can still be expected to generate positive future total returns, albeit at lower than average levels.

For example, imagine that you are looking at a cyclical high-growth company and use a discount rate of 25% (r = 0.25). If the stock is 10% over-valued, you are still expected to earn 15% per year holding this investment.  Yes, 15% is worse than 25% but still a decent number. Definitely not something you would want to go short. 

Just because something is fairly valued or even somewhat over- valued, does not automatically mean you should sell this investment or especially short it. Considering typical uncertainty around estimated growth rates and future dividends, it’s easy to make a wrong conclusion.

Investors talk about market valuations with a similar misconception. They say things like “markets are expensive, I better sell”. Even by the most conservative standards, today’s long-run expected equity return is still a number that is well above 0. Should you panic, sell equities or go short based on this forecast?

I find that when investors talk about high market valuation, they are not technically discussing the long-term expected returns, which is what valuation models are all about. Instead, they are trying to find ways to avoid the near-term pain of the next market correction / recession / bubble bust. Yes, bubbles and recessions do happen often enough to worry about. And yes, equity returns become negative during these instances which typically last for a couple years. But investors cannot avoid these periods based on the simple ‘over-valuation’ arguments.

As I write this, we could be sitting at the very top of the market. And indeed, if I just arrived on planet earth and looked at today’s valuations for the first time, I would feel pretty good about forecasting a negative market outcome for the next decade. And even then I can easily be wrong - what if the market peak is in 2020? 21? 22? What if another melt-up is on its way? In reality however, I don’t get to see valuations for the first time, and so I would have had to make a dire market forecast many times already in 2018, 17, 16, 15, 14, 13 etc.

Valuation models do not tell you where the local peak is. If you follow valuation models to time the market, you will be wrong a lot and miss a lot of the positive returns that the markets provide. I believe that the usage of valuation ratios to try to avoid the pain of recessions is a large contributing factor to the poor market timing and over-diversification during the past decade which resulted in the largest cost of investing. If you don’t want to experience the equity-like drawdowns in your total portfolio, there are other tools like dynamic asset allocation, momentum and volatility forecasting that might work better than valuation-based tools.

What valuation models do tell you is that equities on average are expected to earn a positive return number that varies over time from a low to a high range.

This blog is not against valuation. I am a big fan of valuation concepts and of the famous value investors. It is about the common mis-conception about valuation models that leads to their mis-use in the attempts to time the market, which ironically many value investors caution against doing.