Academic journal article New England Economic Review

Are Stocks Overvalued?

Academic journal article New England Economic Review

Are Stocks Overvalued?

Article excerpt

By most standards, the price of equities in the United States has risen remarkably rapidly during the last 15 years. Since 1994 alone, the Standard & Poor's index of 500 stock prices has doubled. Although the rapid growth of corporations' profits has propelled the price of their stock, shareholders also are willing to pay a greater price per dollar of their companies' profits, and the valuation of corporations' earnings now is nearly as high as it has been since World War II.

In the past, the value of equities often has been greatest when shareholders expected corporations' earnings to grow most rapidly. Now that the current business cycle recovery has matured, this explanation for the recent rapid appreciation of the price of stocks seems more tenuous. To be sure, many analysts predict that their companies' earnings will increase, on average, about 15 percent at an annual rate over the next year and one-half. Macro forecasts, on the other hand, expect earnings to grow more slowly and to decelerate toward the growth of GDP, now that the economy is near the limits of its productive capacity.

For the moment, the value of equity may rest on the growth of earnings, but in the longer run the price of stocks depends on the return that corporations earn on their investments, the growth of their opportunities for making new investments without sacrificing their return, and the return that shareholders require of their stocks. Recent data do not yet indicate that corporations' capacity for earning a profit is greater now than it has been during other business cycles over the past four decades. As impressive as the recent growth of reported earnings has been, much of this growth can be attributed to the recovery of profit margins lost in previous recessions as well as to corporations' sharp reduction of leverage during the past five years. If shareholders expect profits to continue rising rapidly in coming years, then even the simple deceleration of earnings as predicted in macro forecasts could precipitate a substantial drop in the value of equity. If, on the other hand, shareholders do not anticipate a rapid growth of profits, the prevailing high value of equity rests, instead, on shareholders' requiring a lower rate of return from their investments in equities today than they had in the past.

The first section of this article compares the recent price of stocks to traditional standards for valuing equities, finding not only that prices are high by almost all measures but also that the appreciation of equity has been exceptionally dependable. The second section discusses a simple model for valuing equity, emphasizing the importance of shareholders' discount rates, as well as companies' returns and growth, for setting the value of equity. The third section uses the implications of the model to compare the recent data for returns and growth with the value of equity, concluding that companies' recent performance does not support fully the current price of stocks. Although the current values of corporations' assets and earnings in financial markets exceed those that prevailed in the 1960s, the rate of return earned by corporations is only three-quarters as great as it was in the 1960s. The article concludes that a lower shareholders' discount rate, perhaps fostered by the consistently high growth of profits during much of the 1990s, could explain the prevailing value of equities. If so, this value might be prone to collapse once the current expansion matures and the growth of profits subsides and becomes more volatile, thereby ending the exceptional pattern of high returns with little risk.

I. Recent Experience

The rate of appreciation of equities has been remarkably high during the past 15 years. For much of this century, the average annual rate of return on equities, comprising dividends and capital gains, has averaged between 8 and 10 percent (Bernstein 1997). Since 1979, this return has averaged 18 percent; the rate of appreciation of equities alone has exceeded 15 percent. …

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