How to tell if the stock market is overvalued
Stock prices are generally determined by market expectations.
Investors pay premium by buying up stocks when they are positive about the future. When they are pessimistic, they oversell and depress stock prices.
The rise in the stock market recently suggests that investors are hopeful about the economic recovery next year, as vaccination increases amid the improving COVID situation.
We discussed previously in this column that we can measure the premium of a stock by simply deducting the value of a stock’s earning assets per share from its market price.
Such premium, which represents the value of a stock’s growth opportunities, increases when investors pay more for a stock’s future growth.
For example, if we want to know how much premium the market is paying on AC Energy (ACEN), we need to determine first the value of its earning assets.
Under a no-growth assumption, we can discount ACEN’s trailing earnings per share of P0.10 to derive its intrinsic value at P1.07 per share.
By comparing ACEN’s market price of P11.30 per share against the value of its earning assets at P1.07, we can estimate a premium of P10.25 a share or 90.6 percent.
This huge premium indicates the level of the market’s optimism on the stock’s future earnings growth potential.
But if investors are pessimistic about a stock’s prospects, they will demand discount against its intrinsic value.
For example, if we discount LT Group’s (LTG) trailing earnings per share of P1.36 and discount it at current risk, we can derive the value of the stock’s earning assets at P13.40 per share.
But the market is valuing LTG at P9.90 per share only, which indicates a discount of P3.46 per share or 34.9 percent.
Again, this large discount, similar to premium, reflects the investors’ lack of confidence in the stock’s outlook.
Earlier this year, when the vaccine rollout started, the stock market was very hopeful of a faster economic recovery.
The rise in share prices enabled the average market premium to recover to 27.2 percent, which matched the premium before the crisis happened.
But when the government began to implement lockdowns again due to the resurgence of COVID cases, the average market premium slowly declined to zero, which caused the Philippine Stock Exchange (PSE) Index to lose by as much as 500 points.
Today, with the market back to where it was at the start of the year, the average market premium is also recovering fast now at 38.5 percent.
By historical reference, if we will compare the current premium to prepandemic levels, which averaged 41 percent from 2014 to 2018, we can say the PSE Index may be getting close to a near-term top.
At 41 percent premium, the theoretical target for the PSE Index is 7,522, which is 4.3 percent away from the current level.
But this target may not be achieved if interest rates will continue to go up.
Remember that the discount rate determines the value of earning asset of a stock. An increase in interest rate will raise discount rate of the market, which will lower its intrinsic value.
When intrinsic value goes down, assuming the stock price remains high, the average market premium will go up, making the stock overvalued.
Under this scenario, if, let’s say, the 10-year bond yield goes up to 5.65 percent, the average market premium could easily go up to 43.1 percent.
At any rate, it looks like the PSE Index may be due for a correction soon, as share prices have already advanced ahead of expectations.
Two weeks ago, the average earnings yield at 16.7 price-to-earnings (PE) ratio was 5.8 percent. When we compare it against the 10-year bond yield of 4.7 percent, the stock market still enjoys an excess return of 1.1 percent.
But today, with higher PE ratio of 18.1 times, the average earnings yield has gone down to 4.7 percent, while interest rate continues to go up to 4.97 percent, resulting in a negative return of 0.3 percent.
When bond yields are greater than earnings yield, it only means that the stock market is entering the overvalued territory.
While it is good to see confidence coming back to the market, we should also be aware of the risks that come with it. INQ
