CHART: Value’s Back - Why Do Starting Valuation Points Matter? Historical Correlation to Forward Returns
Why do valuation starting points matter? Historically, they show a correlation to forward market returns. Value’s current valuation discount of 41% on forward price-to-earnings (as of 9/30/22) indicate favorable returns relative to growth. Value’s back…and it’s only just begun:
Why Do Starting Valuation Points Matter? Historical Correlation to Forward Returns.
One might ask, "Why the focus on valuation starting points?" The answer is because it matters! Historically, starting valuations have shown strong correlations to forward returns of the market, as demonstrated by Robert Shiller who pioneered the CAPE (cyclically adjusted-price-to-earnings) ratio. Extending this analysis to look at the relative valuation multiple of the Russell 1000 Value compared to the Russell 1000 Growth demonstrates an interesting and similar relationship.
Looking back over monthly data from the last 25 years for the Russell 1000 style indices, a clear trend emerges. Value has historically traded at a discount to growth on forward price-to-earnings ratios, which is not unexpected given the difference in growth rates. However, when that discount becomes extreme, it has been an attractive entry point for value. In fact, when value’s discount has grown to 40% or more, value has outperformed growth by more than 5% per year when looking at forward 5-year relative returns—with a 100% success rate! As of the end of the third quarter of 2022, this discount was 41% even with the significant outperformance seen since 2020. Based on the linear trend line, this starting discount would equate to 5.4% annualized value outperformance for the forward 5-year period. Value is back and it’s only just begun. (chart)
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