Pricey U.S. Equities—Implied Innovation?

What are we to make of the following graphs? Figure 1 presents the long historical view of the Price-to-Earnings ratio on the S&P500 Index. Figure 2 presents a similar view, adjusting the P/E ratio for the impact of inflation on earnings.

Figure 1

Standard Price/Earnings Ratio for the S&P500 Index (average of all companies)

Current S&P 500 PE Ratio: 19.04 -0.19 (-0.97%)

4:29 pm EDT, Tue Aug 5

Mean: 15.52  
Median: 14.56  
Min: 5.31 (Dec 1917)
Max: 123.73 (May 2009)

Price to earnings ratio, based on trailing twelve month “as reported” earnings.
Current PE is estimated from latest reported earnings and current market price.
Source: Robert Shiller and his book Irrational Exuberance for historic S&P 500 PE Ratio.

Figure 2

Cyclically-Adjusted Price-Earnings Ratio for the S&P500 Companies


Current Shiller PE Ratio: 25.39 -0.25 (-0.97%)
4:29 pm EDT, Tue Aug 5

Mean: 16.54  
Median: 15.93  
Min: 4.78 (Dec 1920)
Max: 44.19 (Dec 1999)

Shiller PE ratio for the S&P 500.

Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10 — FAQ.

Data courtesy of Robert Shiller from his book, Irrational Exuberance.

Against these measures, stock prices today seem high. Looking over the last 130 years, you see big spikes in P/E ratios suggesting bubbles “irrational exuberance” in advance of capital market instability (1929 stock market crash, the Internet bust of 2000, and the Panic of 2008). Apart from those extreme events, the P/E ratios of 19x to 25x are relatively high. Is this a run-up to another bubble? What questions should the canny observer ask about high P/E ratios?

Let me frame a (wonkish) reply in terms of finance theory, which suggests that the size of a multiple is driven by two main factors: risk and expected growth. For instance, the widely-used Price/Earnings multiple can be decomposed into two factors:

Stock Price/E(EPS) = 1/r + PVGO/E(EPS)

E(EPS) is the earnings per share expected to be reported next year. The factor “r” is the required return on equity, which is determined by risk. And PVGO [1] is the present value of growth opportunities per share, an estimate of today’s value of investments expected to be made in the future. The term, “growth company,” is not defined by the growth rate of sales, earnings or assets, but by the size of PVGO relative to the market value of equity.

In other words, the P/E ratios of “growth firms” are typically sizable, and driven significantly by attractive future growth opportunities. One can decompose other ratios in a similar fashion. But the key idea is that multiples reflect important economic phenomena. To judge whether a multiple is appropriate, one should look into the underlying economic fundamentals and critically evaluate the assumptions of the model. [2]

So, let’s consider the possibilities. Suppose that “r” is 10%, the going risk-adjusted rate of equity return for the average low-growth firm, such as a public utility. Therefore, 1/r would equal 10.0. Compared to the average P/E ratios for the S&P500 (either 19 or 25), this implies that the present value of growth opportunities these days is simply enormous, accounting for 45-60% of the value of the S&P500. What might explain this huge growth component?

One possibility that you hear mooted on financial talk shows is that the market is “overheated,” “getting ahead of its skis,” and even, “a bubble.” We’ve certainly seen frothy conditions before and shouldn’t be surprised to see them again. The problem is that you could summon up some kind of psychological explanation for market conditions virtually any time. Psychology is always useful as a warning flag; but it won’t tell the investor exactly what to do. Generally, if you think that the market is getting overheated, you might cash out, buy put options, or sell short. But research suggests that trying to time the market by trading actively is an easy way to lose money.

A second possibility is that investors embrace some realistic growth phenomena that justify these huge PVGOs. If so, the canny investor should try to identify the source of these growth opportunities. One helpful resource will be this year’s University of Virginia Investing Conference —November 13-14—the theme of which will be “Investing in Innovation.” Innovation is perhaps the most important foundation for growth, and PVGO. The conference will offer insights about growth prospects in fields such as information technology, energy, health care, and monetary policy. Once again, we are booking an impressive collection of speakers. As of today, speakers will include these (additional speaker are in the offing):

  • Charles R. Cory (MBA ’82), Chairman of Global Technology Investment Banking & Managing Director, Morgan Stanley
  • Richard Fisher, President & CEO, Federal Reserve Bank of Dallas (schedule pending)
  • W. Barnes Hauptfuhrer (MBA/JD ’81), Chief Executive Officer, Chapter IV Investors
  • Robert J. Hariri, Founder, Chairman & Chief Scientific Officer, Celgene Cellular Therapeutics
  • Ned Hooper (MBA ’94), Partner, Centerview Capital
  • Robert J. Hugin (MBA ’85), Chairman & CEO, Celgene Corporation
  • Samuel D. Isaly, Managing Partner, OrbiMed
  • Nancy Lazar, Partner, Cornerstone Macro
  • John Siegel, Partner, Columbia Capital
  • Michael Sola, Portfolio Manager, T. Rowe Price
  • Kathy Warden, Corporate Vice President and President, Northrop Grumman Information Systems

“Early bird” registration discounts end tomorrow, August 8th. Sign up this week to get the highest return on your conference investment.

In all probability, today’s high P/E multiples are due to a blend of buoyant investor psychology and genuine growth opportunities. If so, this puts a high premium on thinking critically about investment themes, trends, and market sentiment. Conferences are one excellent means of sharpening your own thinking. Join us in November!

  1. Stewart Myers originally suggested the important role of growth options in the valuation of the firm. See his paper, “Determinants of Corporate Borrowing,” Journal of Financial Economics, 5:146-175 (1977). The decomposition of P/E presented here is discussed more fully by Myers in his book with Richard Brealey and Franklin Allen, Principles of Corporate Finance. []
  2. Though widely used, and simple to use, investing on the basis of P/E multiples is vulnerable to several potential problems, such as the dependence on GAAP accounting practices, which afford managers rather wide latitude in reporting the financial results of the firm. Also, the P/E ratio can be computed using backward-looking or forward-looking earnings. For growing firms, the difference in financial performance between the year just past and the year ahead will be material. In addition, a focus on Earnings per Share ignores important effects of capital investment, investment in working capital, and depreciation. []
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Should I work for this company?

The summer is a time of endings and beginnings. We’re about to enroll the Darden Class of 2016,
among whom many students are looking to end one career path and embark on another. Alums I’ve been
speaking with recently, took vacations, found the time to stop and reflect, and confronted the itch to
change employers. And for the Darden Class of 2015, who have had summer internships, this week is
probably the closing act: companies will start to make full-time offers. About two-thirds of Darden’s
summer interns get offers of permanent employment from their summer jobs. Common to all of these groups is a fundamental question: “Should I work for this company?”  Let me help you reflect on this. [1]

How not to decide

Start by dispensing with some of the most frequently-heard—and worst—reasons to sign on, such as money, power, fame, convenience, or lifestyle. Mind you, these aren’t trivial; and a partner or mentor may place them at the head of the parade. But these considerations can prompt one to make a decision that seems justified in the short run, but that in the long run may be regretted.

Where to start

The way to begin is to start with a sense of purpose, or intent, or calling. As Stephen Covey once wrote, you must “start with the end in view.” For a few people, this “end” will entail a clear vision of exactly what one will be doing in a few decades. But for most of us, the “end” will amount to an intuition about the kind of impact one wants to make, the kind of legacy one would want to leave, or the help one would want to give to others. If you have a vision or intuition about your “end” in view, everything else will be noise. As the Psalmist said, “Without a vision, the people wander.” If you don’t know where you’re going, any road will take you there.

The guiding principle

If you address the question of where to work with the end in view, then you get focused on how to get there. This focus drives you to one overarching principle: You should go where you believe that you can you do your best work. Thinking in terms of one’s “best work” necessarily focuses on the impact of one’s life and helps to define priorities. I don’t mean to suggest that defining one’s focus and priorities is easy. But finding the signal despite the noise is indispensable to charting a course. Think about the implications of this principle:

  • Go. This begs you to reflect on how you will leave where you are now, and how you will gain access to the place you should be. Is now the time to go? Is your team depending on you to finish some vital work? Will you slam the door behind you, and leave bitter co-workers behind? Leaving well is one of the hardest challenges in a career.
  • Where. In what sense is your best work you contingent on a place? Is it a physical location, close to friends and family? A virtual space that grants you connectivity to people who amplify your talents? A spiritual space that gets you in the zone for great work?
  • You. Are you waiting for someone else to decide for you? You must own the issue. Are you straining over the decision because you simply don’t want to face it?
  • Believe. This takes courage. When you decide to work for a company you must embrace a lot of uncertainty about the industry, company, your supervisor, and even yourself. Have you thoroughly assessed all of these uncertainties? Some are certainly groundless. But there may be good cause for doubts, and perhaps some fears. Ultimately, to decide requires a stroke of faith. Some people gain that faith through serendipity, “signs,” or a feeling of being called, a nagging idea that just won’t go away.
  • Work. What is the work that you want to do? Like to do? Are prepared to do? Will this company let you do it? Or at least grow into it? And let’s not define “work” too narrowly. Your life’s work could also include serving a community, nurturing loved ones, or repairing some nagging interpersonal problem. Think about the balance of all of these possible demands over the course of your life.
  • Best. This is the most important word in the whole question. You shouldn’t settle for just any old work. Life is too short for that. One wants to have an impact with one’s life and arrive at a good end. The notion of “best” should trigger some deep reflection on how you define success. If you start with some sense of the end in view, your best work will start to define itself.


“You should go where you believe that you can do your best work.” Spoken plainly, this principle seems obvious, hardly a slap-the-forehead insight. Yet in my decades of working with students, alums, and searchers of all kinds, I observe how slowly people come around to this conclusion. Often late in life, they will wrap their career choices based on money, power, fame, convenience and lifestyle in some rationalization about “best work”–but it always sounds hollow.

It is better to start with the end in view. That way, the steps to get there tend to define themselves.

  1. Those interns who are in the home stretch and really hope to gain an offer might find some of my past
    advice helpful. There is a range of things one can do to improve the odds of getting an offer:

    A. Actually ask for the job. Too many summer interns simply don’t “close the sale” (see this.)

    B. Become known. “Lean in,” in Sheryl Sandberg’s parlance. Too many summer interns lean back and fade out (see href="">this.)

    C. Finish at a sprint; don’t coast to the end. Research suggests that the most recent perceptions are very influential to decision-makers. Even if you’re finished with your summer project, walk around and volunteer to help anyone else (see this.)

    D. Quell any sense of entitlement; you must earn the offer. In most settings, arrogance damages, rather than strengthens, career prospects (see this.)

    E. Even if the news isn’t good, exit gracefully. (See this.)


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