Market Down But Valuation Up?
One of the most common mistakes traders make is investing based on the value of a certain index, whether it be the Dow Jones, Nasdaq, S&P 500, etc.
An index’s value has little to do with the overall market valuation. Just because the Nasdaq now trades 51 times higher than it did 40 years ago does not mean stocks trade at a 51 times higher valuation than before.
If that would be the case, then if traders paid 5 times free cash flow in the 70’s, they would now pay 1250 times free cash flow today!
The overall stock market has, and always will, trade according to basic business fundamentals – an average multiple on top of current and future cash flows. Generally, when the market falls below this average, it will most likely increase in the near future, and vice-versa.
By viewing the stock market as a business investment, you will be able to spot when it is undervalued or overvalued much better than the average investor who simply looks at an index number.
Case in point. Today all three major indexes dropped about a half percent, however the market valuation increased. This scenario occurs when stock prices do not fall far enough to align with lower company earnings (thus increasing the stock market’s overall P/E ratio).
Lower company earnings: + P/E ratio
Lower stock price: - P/E ratio