By Thomas J. Raymond Jr., CFA
Can there be two correct answers at the same time to a single question? On the surface, it sounds illogical, but that didn’t stop Akira Kurosawa from exploring this concept in his 1950 film, Rashomon. The movie centers on a crime that took place in a forest and the curious accounts of it. Four witnesses had four different depictions, dependent on how they observed the incident, and each was so persuasive that the actual truth was unclear. The movie has since lent its name to what is now called Rashomon Effect: the observation that ambiguous, complex matters can have different interpretations. There are broad takeaways with political, business, and social implications. In the financial markets, the concept of value, too, has increasingly become a matter of perspective.
The intrinsic worth of an asset can be tough to determine at times, but necessary to understand, to see if a premium or discount is being paid. It’s true in many realms, from grocery shopping, to home purchases, and certainly with investing. As it relates to stocks, we need to understand earnings to see where valuations and true worth reside. But it’s a decided challenge in today’s COVID-19 environment, and it starts with an ‘E’ that is more ambiguous than ever.
The E in P/E
The variability surrounding future corporate earnings is at extreme levels, which makes the math surrounding the price-to-earnings (P/E) valuation metric feel like advanced calculus. For starters, companies in various industries, from health care to energy, have announced they will refrain from guidance on future profits. This adds to the guess work with COVID-19’s economic effect on corporate America, and perspectives are rapidly evolving. Notably, consensus earnings estimates from I/B/E/S (Institutional Brokers' Estimate System) data for the Standard & Poor’s (S&P) 500 started the year at 10% growth for 2020. At the end of March it was 1% and now it’s at minus-20%.1 That’s a lot of second-guessing by Wall Street analysts in a short window of time, and there is likely more to come. What this means is there is plenty of murkiness to earnings, and so too with stock valuations.
It’s a new age economy, which has its associated ambiguity. No longer is the market dictated by industrial, old-line businesses, as we have seen a number of them earning become former Dow Jones Industrial Average constituents. Rather, value has been increasingly bestowed to intellectual property, reputation, or the vision of a charismatic founder. Indeed, intangible assets have a lot heavier imprint on markets as they account for roughly 84% of the S&P 500’s value.2 It’s a weighting that has been on a steady climb since 1975 when it was 17%, leading to curious prices of many upstart technology businesses. But if earnings are hard to figure today, we presume so too will the value of brands or human capital with COVID-19 turning our lives upside down. Intangible assets have long had a subjective quality, and likely a higher degree of arbitrariness given the current unknowns.
We don’t know where COVID-19 will take us, but that hasn’t stopped the speculating. This creates a lot of variability with valuations, which isn’t made easier by a growing weighting of intangible assets. So, we see the many perspectives of value as the Rashomon Effect has a grip on the markets. But there can only be one right answer, and the work of finding it is a lot harder during this complex, ambiguous time.
1 Summarizing S&P 500 EPS Estimates Over Various Timeframes, Seeking Alpha, April 20, 2020, I/B/E/S data by Refinitiv.
2 $21 Trillion in U.S. Intangible Assets Is 84 Percent of S&P 500 Value, IP Close Up, June 4, 2019.
Thomas J. Raymond Jr., CFA, is a senior portfolio manager for Abbot Downing in Philadelphia. He can be reached at email@example.com.
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