What is the best way to value a stock?

Why do many popular valuation measures use a company's earnings as the main representative of fundamental value, rather than dividends?

Many popular valuation measures, including the "cyclically-adjusted price/earnings ratio", or CAPE, use earnings as the main representative of fundamental value rather than dividends.

But John Burr Williams, who is thought to have invented the theory of stock valuation as a Harvard University Ph.D. student, argued that earnings are only a means to an end, and that investors ought to focus on dividends instead.

It has now been more than two decades since the CAPE ratio emerged as one of the investment industry's preferred valuation ratios, yet its intellectual roots trace as far back as 1934.

Its ongoing success has been marked by its ability to identify periods with higher prospective returns and lower prospective risk, creating a yardstick of value.

Re-thinking the way stocks are valued

However, increasingly, researchers have raised questions about the reliability of the CAPE ratio as a long-term valuation measure. One of the most contested points is that the 10-year average real earnings figure--the denominator in the CAPE ratio--is merely a crude proxy of a stock's intrinsic value.

This has been structurally challenged recently by prominent academics. For example, Jeremy Siegel suggested that changes in generally accepted accounting principles have depressed reported earnings in recent decades, leading to current CAPE ratios that are too high compared with historical levels, thus understating prospective returns.

It should be stated that we deeply respect the foundation and empirical evidence that supports the CAPE ratio as a valuation measure, and while we acknowledge its broad imperfections, we continue to measure it across the investment universe as a fundamental assessment of value. However, we also like to complement its insight with the cyclically-adjusted total yield, or CATY.

Investors eat dividends, not earnings

The logic underpinning the CATY ratio is compelling. In contrast to earnings, payouts are a cash flow, representing the cash distributed to shareholders via dividends and share buybacks, that is, total payouts. Since the value of a stock is the present value of its future cash flows, not its earnings, total payouts are closely linked to a stock's intrinsic value.

Also, in contrast to earnings, today's total payouts are sensitive to a management's capital allocation decision--whether or not they distribute or retain cash flow.

Reinvesting more today will decrease current total payouts, but should boost payouts in the future. So, to assess a firm's valuation, a long-term perspective is necessary. It therefore makes sense to average across 10 years of total payouts. Earnings meanwhile, due to the contemporaneous matching of revenues and expenses, are less prone to this asymmetry. In many respects, the averaging of total payouts over multiple periods is more important for CATY than it is to CAPE.

CAPE versus CATY

We now turn to evaluating the merits of CATY compared with CAPE as a long-run valuation measure. To recap, the CAPE is calculated by dividing the stock's current price by its 10-year real earnings-per-share average, while CATY is calculated by dividing the 10-year average of real total payouts by the price. Both measures are based on a ratio of fundamentals and the current price.

Overall, these measures track the relative valuation of a stock market similarly over time. Yet, there were several periods of divergence: For instance, taking the US stock market as an example, during the 1950s and 1960s, earnings grew faster than dividends in the post-World War II era as companies retained a greater fraction of earnings, leading CATY to point to a higher level of overvaluation than CAPE.

CAPE and CATY fell back in sync during the 1990s through the time of the global financial crisis, but have diverged again since. At 30 June, the CAPE was 79 per cent above its long-run average, while CATY was just 42 per cent over, both measures point to an overvalued market, but CATY to a far lesser extent.

How do we use these metrics?

We believe that both metrics are effective long-run valuation measures, and the CATY ratio is at least as predictive as CAPE over the extended history since 1881, with both explaining approximately 18.1 per cent of the variability in returns.

Importantly, the CATY has also confirmed its relevance in recent times, with the evidence showing the CATY ratio explaining more of the variability in returns than the CAPE since 1970; approximately 23.6 per cent versus 8.8 per cent.

Therefore, the way one uses this valuation metric really depends on whether they prefer to measure value using "total payouts" or "total earnings".

To our way of thinking, total payouts are less prone to changes in accounting standards and are potentially more effective when gauging the valuation of equity markets on a cyclically-adjusted basis. For this reason, it is a key input into our fundamental process and should help investors better meet their needs.

More from Morningstar

• Weighing up listed investment trusts

• Why owning the market doesn't always pay

• Make better investment decisions with Morningstar Premium | Free 4-week trial

Dan Kemp is chief investment officer, Morningstar Investment Management EMEA.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.