How does one measure fundamental value? The chart shows two such measures – “Q” and the “cyclically adjusted price earnings ratio” (Cape).
The first of these measures derives from the work of the late James Tobin, a Nobel laureate economist. Q is the ratio of the value of an individual stock (or of the stock market as a whole) to net assets, at replacement cost. Tobin initially proposed this ratio as a way of explaining investment. Andrew Smithers of London-based Smithers & Co, from whom I have obtained the data, realised that Q could be turned round, to value the stock market, instead: high Q then forecasts not so much an investment surge as a stock market fall, and vice versa. If the stock market values the net worth of a company at far more than it costs to re-create its assets, either assets should expand or the market valuation should fall. In practice, argues Mr Smithers, it is more likely that the market is wrong than the investment decisions of companies.
The second of these measures has been used, in particular, by Robert Shiller of Yale University. The denominator is a 10-year moving average of earnings, in real terms. The purpose of this adjustment is to eliminate the cyclical effects on earnings that make price/earnings ratios look low at cyclical peaks, when earnings exceed sustainable levels. At times of rapidly increasing leverage, such as the 2000s, cyclically unadjusted earnings are likely to prove particularly meaningless because they are intensely vulnerable to changes in economic conditions. Leverage, after all, works both ways.