Why Is a High Valuation in One Industry a Low One in Another?

In investing, as in so many other arenas, the questions with the most complex answers tend to start with one word: "why." From this month's Motley Fool Answers mailbag comes a particularly good question from a listener who's curious about why we gauge the values of companies and assets with the metrics we do, and why different industries and businesses seem to be held to such different standards.

To answer, special guest Buck Hartzell, director of investor learning and operations at The Motley Fool, joins hosts Alison Southwick and Robert Brokamp. In this segment, he talks about the relative merits of different industries, and the inescapable relationships between inflation rates, interest rates, and risk and reward in investing.

A full transcript follows the video.

This video was recorded on Oct. 30, 2018.

Alison Southwick: The next question comes from Ronald and he writes, "How and who established the traditional metrics that we use for valuation and why has that changed over time? Why are different industries and businesses being evaluated with different valuation metrics vs. other traditional metrics? For example, 20x forward earnings being cheap vs. expensive for different businesses and industries?"

Buck Hartzell: Ronald, that's a little question, and it's pretty concise.

Southwick: The answer?

Hartzell: The answer is a big one!

Robert Brokamp: [Laughs] So settle in, everybody.

Hartzell: See, I don't get in trouble. I'm just a guest here, so if you guys don't like the depth that we're going into in this answer, then you can tell them and they won't have me back again, which is fine.

Southwick: I'm going to get comfy.

Hartzell: But the short answer is some industries are inherently better than others, so that's the quick answer. Cereals, for instance. Cereal companies have earned 15% return on equity for a long period of time. They have competing products and that's just been a really good industry. There's other industries like airlines that typically -- they've done better recently -- that nobody earns great returns with the exception of maybe Southwest or one or two airlines. So some industries are particularly good and some are particularly bad, generally.

Now the longer answer, as to multiples and valuation of stocks, is a more complex thought, but I think it's important and it's pretty timely. It's understanding the relationship between inflation rates, interest rates, bond prices, and stock prices. We're going to take a little dive into that and hopefully it's useful to you.

Interest rates are driven a lot by inflation. The inflation rate [and I looked this up yesterday] is running about 2.3%. It's pretty low and it's been modest here for quite some time. So that's the inflation rate. And what happens when banks set interest rates for different loans and things like that, they're going to have to charge above the inflation rate or they lose money. So typically banks will charge about 3% premium to whatever inflation is. So if you see inflation is 2.3% you can expect that loans and stuff like that will be at about 5% or so.

That interest rate, in turn, influences bond rates. I looked at bond rates and we're at a weird time, here. We'll get back into this later. I looked at T-bills. 10 year T-bills are at about 3.14% right now, so on a $1,000 bond you would be getting $31 a year in interest and that's a 10-year. If you look at 30 years, you only get 3.4%, so there's not a huge premium for that extra 20 years. That's a little bit weird. We won't talk about the yield curve, but those are bond rates. They're not spectacular and they're certainly not a way to get rich right now at 3% for T-bills.

Then we look at stocks and multiples. Right now the S&P 500 is trading just below 18x earnings if you look at the S&P 500. Now, we compare those. Here's why it's important between stocks and bonds. Bonds are a replacement for stocks. They compete for money. So if you can get 6.5% guaranteed out of a bond, you assume more risk when you buy stocks, because if something goes bad [Sears shareholders out there], there's nothing left for the equity holders, but the bond holders precede them so they get preferential treatment. If you're going to take that risk for being an equity holder, you want to earn more than the bonds. As bond rates go up, then equities become less attractive.

So at 18x earnings, when we look at the S&P 500 multiple to compare those two, we need to convert it to an earnings yield. That's just the inverse. So if you have P/E of 10, one divided by 10 would be a 10% earnings yield. We have 17.98% which turns out to be a 5% earnings yield on the S&P 500.

Now here's the interesting thing. If you buy a bond, it doesn't change. You're going to get that coupon and that's what you get until it matures and it goes to the end.

Brokamp: That's what I call fixed income, because it's fixed.

Hartzell: Right, it's fixed. You get no growth. But when you invest in stocks, earnings generally grow. On average they grow about 7% a year if you look back historically. So what happens is investors typically will take a little bit less on the earnings yield for stocks than they will in comparison to bonds. Now here's the weird thing today we're getting at and why it's important.

We have a 5.6% earnings yield for the S&P 500 and we have 3% in bonds. That's weird. Usually it would be a discount, and the discount would be if you took the rate for stocks and grew it at 7% a year, usually it's about a three-year period there. So we would expect that stocks would be cheaper. Unfortunately they're not. You're getting more for stocks.

So what does this tell us, that 5.6%? It tells us we should be kind of leery of investing a whole lot of money right now in bonds. Some people, Warren Buffett and others, have talked about the big bond bubble and all of that, so as a result I would be pretty skeptical of putting a whole lot of money in bonds today. And most of the people that have to put it in [like insurers and those kinds of companies], are in very short yielding. They're in short-duration bonds. They're not going to buy that 30-year for 3.4% vs. a 10-year for 3.1%, and they're probably a much shorter maturity than that.

So in summary, here's what we know. Inflation impacts interest rates, interest rates impact bond rates, and bond prices impact stocks. So what happens when interest rates rise [and what we're seeing with the Fed right now is they're raising rates, and there's some signs that wages are growing that are traditional inflationary signs, so we'd expect them to keep rising] the current prices of bonds go down when rates go up. Because if you bought a bond a day ago at a 3% and now it's 4%, well, the old bond has to be repriced to be comparable to that 4%, so the price of it goes down.

Now if you hold it to maturity, that doesn't matter. You're going to get your payments, and that's why Bro tells people to ladder into bonds. Stocks, as well, when interest rates rise, the multiples generally go down. But when we look out right now -- and this is why it gets scary -- is people go, "Stocks look expensive to me from a historical standpoint." Well, you have to compare it to something. There has to be some relative comparison. And right now stocks in comparison to bonds look very attractive.