Valuation I. Baseline Zero Growth Values

Rational valuation of stocks needs to be self-consistent with the valuation of bonds, which are just a stream in time of future cash payments. Stock investors usually use a Price-Earnings ratio (PE), but they rarely consider what the baseline PE is for a bond. The bond market determines the value of relatively certain cash flows, so consideration of the PE of a bond for a baseline valuation is critical for a market-wide self-consistent valuation. A bond has no growth, so this is a zero growth value.

On Friday the US Treasury 10 year note was priced near par to yield 4.61%. Taking the reciprocal we obtain the "PE" of a riskless cash flow stream with no loss of principal, viz., 21.7x. Now corporate earnings have risk. So let's include some risk by using corporate bond yields to obtain a closer baseline estimate for fair value, zero growth PE: Barron's high grade bond index had a yield of 5.83%, and Barron's intermediate grade bond index has a yield of 6.77%. So depending on the risk of earnings, a corporate zero growth PE is worth between 17.2x and 14.8x

Now a bond risk is downside risk only - a bond payment never increased. In a default, it goes down. So this zero growth valuation is rather stern, being stressed by bad events, but not good events. Hence it's a good baseline for further incremental analysis. Companies with valuations near this range are obvious LBO / private equity candidates. Companies with higher valuations (higher PEs) need growth or something else to justify the price. More later in part II.