LA Trip: Elevated Valuations

Just back from a conference and meetings in LA and a recurring theme I heard was that valuations appear high. I heard this regarding both public equities and private equity, rates and credit, as well as real estate. The common refrain was, “Opportunities are scarce and extra caution is warranted.”

The implications of high valuations are different for equity and debt investors, however both face the following challenges:

  1. The first problem with high valuations is that carry (current cash flow from owning an asset) is low. Valuations are often expressed as a ratio or multiple of some cash flow, so high valuations are synonymous with low earnings yields, credit spreads, cap rates, and so on. While prices can always decline, higher carry helps mitigate that risk. Conversely, very low carry leaves much less room for error and may not be sufficient.
  2. A second problem with high valuations is that they can decline (duh!). If valuation metrics are mean reverting and they are on the higher side, then they will likely decline at some point. The question is whether valuations decline from improving fundamentals or declining prices.

Again, valuations have differing implications for various asset classes, but exercising extra caution in expensive markets is rarely a bad idea.

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Disclosures & Disclaimers page for a full disclaimer.

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