11. The Fifth Factor: Fundamentals and Valuation

The investment universe is chockablock with opportunities. Wherever you turn, something new grabs your attention. Interested in a portfolio of battered subprime securities? A stake in the newest emerging economies in countries such as Vietnam and Kazakhstan? If you feel like putting your spare cash to work in a wind farm in Brazil or your brother-in-law’s new gourmet sandwich shop, you can take that risk, or you can opt for the lower-risk alternative of purchasing short-term Treasury bills, even if they provide as little yield as they do risk. Each of these options offers a unique set of risk and return characteristics you need to analyze before you write a check or complete the electronic funds transfer. Although the first four factors that I have discussed can help you navigate your way through a noisy market environment and gauge the best time to make an asset-allocation shift, you need to be able to make your own decision about which particular investment offers the best combination of risk and return—the best fundamentals. And that is where my fifth and final factor (valuation) comes into play.

“Relative valuation” is the single most important criterion in determining how you will separate the most attractive markets from the ones that are only mildly interesting and those that are downright unattractive. Regardless of the type of investment you’re mulling—that sandwich shop, say, or blue-chip U.S. stocks—valuation tools will help you make an objective decision. That becomes particularly crucial the more volatile and fast moving markets become, when emotions distort asset prices. The more you focus on metrics that help you identify asset classes that are over- or undervalued, the more opportunities you have to outperform. Take the autumn of 2008, when Wall Street held a yard sale. Indeed, prices were so low in one of the worst market blowouts in decades that valuation issues became almost academic. Hedge funds and other investors who had bought their holdings with borrowed money that they now were being told to repay pronto hit the “sell” button over and over again. It wasn’t just stocks that suffered; the prices of high-quality bonds were battered so severely that their yields (which move in the opposite direction to prices; the cheaper a bond gets, the more attractive its coupon becomes when calculated as a percentage of the current price) became downright enticing. Since 1996, lenders have historically asked for and received about 1.6 percentage points of extra yield in the shape of higher interest rates in exchange for purchasing a triple-B rated corporate bond rather than a Treasury bond. After the rout of autumn 2008, however, the same triple-B corporate bonds offered an astonishing 4.6 percentage points of extra yield! By historic standards, the corporate securities were the valuation equivalent of finding a bona-fide designer handbag for sale for $50 at your local Wal-Mart.

In the early stages of the credit crunch that wreaked havoc on financial markets in 2008 and into 2009, several strategists believed that the emerging markets would offer some form of shelter from the mayhem. Emerging market economies, these optimists argued, would hold out because they were less connected to the global economy, so when the United States sneezed, they wouldn’t catch cold. I wasn’t so sure, as I told investors early in 2008. The problem? Even if they managed to hold out against the tide, emerging markets were, as an asset class, relatively expensive when measured against the S&P 500. The MSCI Emerging Markets Index boasted a price/earnings ratio of 15 early in 2008, while the S&P traded at 18.2 times earnings. Yet as recently as March 2002, the price/earnings ratio of the emerging markets was only a third of that of the S&P 500; its relative value had exploded over the previous 6 years, reflecting analysts’ conviction that growth prospects for corporate earnings in the emerging markets were higher than those in the developed markets. The arguments appeared compelling, but I resisted, for which I would be very thankful later. I was going to assume that the emerging markets stock universe was overpriced until some set of indicators proved otherwise; however, it was also wise to maintain some emerging market exposure for long-term growth and diversification.

Think about the ways in which valuation fundamentals affect a decision most of us face a few times in our lives: whether to buy a new house. Imagine that it’s the summer of 2008, you have just retired, and you are considering a move to Miami so that you can play golf throughout the year. You’ve even found the right house, and it’s priced at a discount! Your friends, however, think you’re nuts. “Haven’t you noticed the real estate market is crashing?” they demand. And they are right. Between December 2006 and August 2008, the value of the average home in the Miami area plunged about 30% in the midst of one of the worst localized housing crashes in American history. But that, along with your desire to live a 10-minute drive from scores of enticing golf courses, is just “noise.” The bigger and more important question you have to address is whether the fundamentals make sense. Is the property fairly valued? If it is very cheap compared to recent sales, you need to figure out why that is, and then whether the current price really represents good value. To answer the question of value, you need metrics that will help you understand the real estate market and the relative value of the home you are proposing to buy.

Your primary consideration should be the fundamentals: Is the home appropriately priced for its condition, its age, its location, as compared to the prices at which other similar houses have changed hands? If the answer is yes, you can think about what the other four factors tell you about both the investment itself and the timing. For instance, the economy may play a role in your decision: If the dollar’s value is low, this might lure foreign buyers in search of winter sun into the Florida real estate market. Understanding the market’s psychology will also help you: After such a plunge in real estate values, there are few buyers, meaning that prices may be discounted. The liquidity factor may also be on your side. If you have a solid credit rating and can make a sizeable down payment, you might be able to finance the purchase even as 60% of banks are scaling back their lending. Momentum may be another green light. The supply of houses in Florida has exploded over the past decade or so as property developers adopted a “build it and they will come” approach; now many sit empty. These four factors are crucial. But at the end of the day, if fundamental indicators tell you value isn’t there in the first place, the rest is academic.

Thinking about investment fundamentals always makes me think about exactly how I earn returns for investors. These returns come either in the form of income (interest payments on bond investments or stock dividends, for instance) or capital appreciation (an increase in the market value of the securities I buy). The goal of valuation metrics is to calculate what kind of income I’m likely to earn and the probability of appreciation or depreciation, measured against the prevailing market price. What price am I being asked to pay for a stream of income, or yield? What is the cost today of what I expect will be a 20% gain in the S&P 500 over the next 2 years? Is the price fair, when compared to other potential investments? This way, I put all available opportunities on a level playing field and am able to make sense of asset classes that may have very different risk and return characteristics, such as bonds and commodities. In all cases, I’m trying to use valuation metrics to decide whether an investment that looks like a bargain is a bargain.

In the world of bonds, where I began my investment career, valuation issues were fairly straightforward. What matters to bond investors is the price they pay for each issue, together with the issuer’s credit quality. The first step is to calculate whether the current market price for the bond you’re looking at is at a discount to the price at which it was issued. That’s pretty easy to do, because most bonds are issued at what’s called “par” value, or the principal amount that investors will receive when the bond matures in 3, 5, 10, or more years. (Most often, that is $1,000.) Once issued, the bond’s price fluctuates in response to a complex set of interconnected factors ranging from the issuer’s credit quality and cash-flow outlook to interest rate levels. But the real question for an investor—as opposed to a trader—involves a simple mathematical calculation. Is the company making enough money to make its interest and principal payments to investors on time and in full? The bet is a binomial one: Either the bond paid off or it didn’t. If the cash was there, and you could buy the bond at a discount, you won over its lifetime. If not, you would lose.

Leaving this black-and-white universe for the Technicolor world of stock market analysis, I had to rethink my approach to investment fundamentals in light of the seemingly endless range of scenarios and outcomes that stocks offered. Will a company hit or miss its quarterly earnings forecast? What if its largest rival achieves a technological breakthrough? Is the company an acquisition target, and can the buyer finance the transaction? Will its chief financial officer cook the books and run off to Tahiti? All of these considerations (and more) play a role in shaping a company’s stock price and thus its market value. Next comes the complex question of whether that market value is appropriate, one made trickier by the fact that stocks—unlike the vast majority of fixed-income investments—don’t ever mature, and few offer much in the way of yield. (Not all publicly traded companies opt to pay dividends on their common stock, and those dividends that do exist can fluctuate greatly.)

But like all markets, the stock market offers tremendous opportunities to perceptive and disciplined investors. Indeed, each surge of emotion, and each lurch in market indexes when momentum temporarily displaces common sense, creates a fresh opportunity for this small group of investors. Sometimes these opportunities are dramatic. By the late 1990s, the giant surge in technology stocks created an outsize valuation gap between technology and telecommunications stocks and almost every other sector. Long-term investors known for their keen eye for market values were left in the dust. By early 2000, Berkshire Hathaway, the holding company that serves as the vehicle through which famed value investor Warren Buffett invests in businesses he believes are undervalued, was trailing the broader stock market by an astounding 50% on an annual basis. In March of that year, hedge fund investor Julian Robertson, another value investing devotee, shuttered his Tiger Fund. Both men publicly voiced their skepticism about the astronomically high valuations investors were ascribing to Internet-related stocks. Sure enough, those investors who trusted their observations about valuation and had the courage to act on them by slashing their technology stock holdings and shifting the proceeds into “value” stocks ended up outperforming their peers for several years to come. Meanwhile, those who argued that the advent of the Internet meant that the fundamental valuation rules had been repealed were left with large losses.

It’s not easy to be a contrarian. In the case of technology stocks, the market defied fundamental valuation indicators for years before the break occurred. Even in more normal times, markets can become excessively bullish or bearish for months at a time. Investors aren’t required to buy when the market is cheap or sell when it becomes pricey. Still, to manage their risk and pursue returns, they need to know where in that valuation cycle they stand.

Valuation metrics include some of the stock market’s most familiar indicators, all of which will help investors separate good investment ideas from those that are bad or merely indifferent. I divide them into three types. The most widely used are those linking the price of a security, index, or other investment to an item on a company’s income statement, such as revenue or profits. By far the best known of these is the ubiquitous price/earnings (or P/E) ratio. (Others include price-to-cash flow and price-to-sales ratios, and the earnings yield.) Next comes a group of valuation metrics tying the security’s market price to something on the balance sheet, such as the price-to-book value ratio. The third category includes yield-oriented measurements, such as dividend yield or yield to maturity.

When I began overseeing stock portfolios, I realized that the valuation methodology I used would depend on the kind of decision I was going to make, and that not all indicators would work. I knew I shouldn’t obsess over whether or not pharmaceutical giant Pfizer’s valuation was appropriate, for all the reasons that I outlined early in this book. Besides, that was for our analysts to decide. Why worry only about the fundamentals of Pfizer’s new drugs? For every pharma company with a poor new drug pipeline, there is another that has a blockbuster product just awaiting approval. What I needed in place of Pfizer-specific metrics or even some kind of insight into the complexities of the FDA’s new drug approval process was a broader indicator telling me whether the valuation of the pharmaceutical industry looked attractive when measured against all the other possible industries in which I could invest. Generally speaking, I needed the most general valuation metrics I could find; the ones that would help me identify times when entire asset classes were overvalued or undervalued. Moreover, some metrics have only limited utility. For instance, cash-flow analysis can prove very useful in looking at the banking and financial services arena, but it simply isn’t relevant when you take a step back from sectors and try to look at comparing valuations among asset classes. When I took over the BankBoston asset-allocation fund and had to decide which asset class to invest in at any given time to generate the best return for my clients, I realized that the valuation tools I needed most were those best able to capture broader valuation gaps between asset classes.

The most crucial “fundamental” metric proved to be the earnings yield model, thanks to its ability to help me calculate the relative merits of stocks and bonds at any given point in time. Also known as the Fed model (a nod to its genesis in the Federal Reserve Board of Alan Greenspan’s era), it looks like an upside-down price/earnings ratio. The P/E ratio divides the price of a stock, index, or other security by the expected or actual earnings for that asset and ends up with a number that can be compared to the security’s peers, industry, or the market as a whole. In contrast, the Fed model begins by taking analysts’ forecasts for the operating earnings of the companies in the S&P 500 for the coming 12 months. You then divide that sum by the current price of the S&P Index itself. (The same model can, of course, be applied to any other stock index.) The result? An earnings yield for the index. If you take that earnings yield and put it on a chart against the current interest rate that an investor could capture by investing in the 10-year Treasury bill, you’ll see an easy-to-understand comparison of the relative allure of stocks and bonds.

This metric offers a simple way to combine earnings, prices, and interest rates to reach this conclusion. When the earnings yield is significantly above the Treasury yield, the Fed model tells me that investors are very pessimistic about stocks and are demanding to be paid an outsize amount of yield in return for the risk of investing in them. The stock market’s earnings yield can fall below Treasury yields in a bull market, telling you that investors aren’t worried about stock market risk and don’t feel any need for the kind of safe haven that triple-A government bonds offer. Edward Yardeni, an economist and strategist at Deutsche Bank in New York during the late 1990s, paid a lot of attention to the Fed model during this period. It proved popular when it not only served as a reliable indicator of past bull and bear market cycles but also provided clear signals that the bull market of the late 1990s was heading for disaster—the ultimate asset-allocation call, for those who were alert enough to catch it. By the first quarter of 2000, the model suggested that the stock market was 70% overvalued. Sure enough, within weeks, the S&P 500 had begun the nosedive that would wipe 40% off the value of the large-cap stock universe over the next 3 years. Midway through this painful period, in the summer of 2001, I joined Harris Private Bank. By then, I was running the Fed model calculations every month. I was sure that just as it had given an early warning of the market meltdown to come, so it would warn me when stocks finally ended up trading too cheaply relative to bonds. It took a while for this to happen, as the terrorist attacks of September 11, 2001 further damaged an already weak economy and the gloom deepened and spread. By the time major stock indexes hit bottom in the third quarter of 2002, one of the worst periods for stock investors in half a century (at that time), the bears were running the show. Even without a dramatic crash of the kind seen in 1987 and later, in the fall of 2008, by the time investors closed their books on September 30, the S&P had fallen 17.3% in only 3 months. For most of the people working on trading desks or running mutual funds, it would be the single most painful period they had experienced firsthand thus far and wouldn’t be matched for another 6 years.

So it wasn’t exactly the perfect time to try making a bullish case for stocks. No one wanted to stick their neck out in an environment like that; everyone who had tried to bet on a turnaround in stocks had lost a lot of money and credibility. Nonetheless, the Fed model had begun to send out signals that I couldn’t ignore. A string of interest rate cuts designed to battle the recession had driven Treasury market yields lower, and stocks were now somewhere between 20% and 30% undervalued. An investment opportunity had been created. Bracing myself, I recommended to our investment policy committee that we should sell bonds and buy stocks until stock market exposure was above the target. For weeks after I made the call, I traveled from one Harris Private Bank office to the next, reinforcing my recommendation to individual portfolio managers. I knew it was a risky decision, but the credibility of my work was on the line—not only with our clients, but with our portfolio managers as well.

Of course, the Fed model isn’t infallible. Critics have argued that it’s a good short-term indicator but that it doesn’t provide long-term signals and that Treasurys aren’t the best assets to compare to stocks. I agree on both counts, although that flaw doesn’t mean the metric is useless. As long as you remember that it works best when you’re trying to understand valuation fundamentals for the coming 12 to 18 months, you can still treat it as a very useful gauge of the relative valuations of the two key asset classes, stocks and bonds. If you believe that Treasury bonds are too low risk to be compared to stocks, you’ll find that it’s easy to substitute the yield on an index made up of triple-B rated corporate bonds for the rate on the 10-year Treasury. Even with these changes and caveats, the Fed model still emerges as the single best way to tackle the first valuation decision any investor will face: whether stocks or bonds offer the greatest upside potential.

The Fed model isn’t the only valuation metric that can help with this critical choice between stocks or bonds. An alternative is the dividend discount model, which calculates all the future dividend flows that the components of a given stock index can be estimated to produce in perpetuity. It’s like the P/E ratio, with the difference that investors actually receive dividends; so it measures the cash return for the index. How much would you want to pay to own that flow of income? Most investors would prefer to purchase it at a discount. So, if you compare the discounted yield to the current market price for those securities, that will give you useful information about the best strategy to pursue. It’s a fairly straightforward calculation: I know or can calculate future dividend payments; I know the current market value and can therefore calculate the implied rate of growth. The glitch, of course, is that dividends aren’t fixed and that not all stocks pay dividends these days. So replacing dividend growth with some measure of long-term earnings growth is a sensible alternative. Doing so means you can capture the anticipated long-term growth in the stock index—that growth is a key objective for any stock investor—and compare that to current market pricing.

These two models are just the starting point, a way to help me understand whether stocks or bonds look more attractive based on valuation fundamentals. But that simply opens the door to a series of fresh questions that must now be addressed, using similar or completely different valuation metrics. It’s a bit like having to make a choice between planning a summer vacation in the Loire Valley in France or California’s Napa Valley. Concluding the exchange rate isn’t in your favor and that hotel bills and other expenses would put too big a dent in the family budget, you decide on California. Now you face an array of new decisions. Will you fly to San Francisco, or put the family in the car and drive? Which airline will you take, and does it make sense to use your frequent-flyer miles? Once there, will you head for a campsite or a boutique bed and breakfast? Working your way through your investment process with valuation metrics isn’t that different. When you’ve made the decision that stocks look relatively more attractive than bonds and other asset classes, you have decided on your direction and destination. Implementing that, and building a portfolio that reflects that decision, means you have to decide which part of the stock market offers the best opportunities. Which valuation metrics will help you figure out whether the U.S. stock market is the best option, or whether you want to steer a greater percentage of your nest egg into overseas stock markets?

Too often, investors miss a step in their thought processes at this point in the analysis. Once they’ve concluded that stocks are the better bet, they move straight past the next logical question (Which stock markets offer the best potential returns?) and instead decide which U.S. market sectors they should emphasize in their portfolios. That’s surprising, given the ever-increasing array of global investment opportunities that become more and more accessible to individual investors each year. Once, “global” investing meant buying American Depository Receipts (U.S.-listed securities) of a few giant European multinational concerns. These days, not only do domestic European markets offer much more diversity, but emerging markets ranging from China to Poland and South Africa provide exposure to new kinds of businesses aimed at exploiting entirely new opportunities. A fresh category, the so-called frontier markets, such as Vietnam and Nigeria, are beginning to attract the attention of institutional investors and ultimately will be accessible to the most risk tolerant of individual investors. You can still use U.S. stocks as the benchmark and see how European, Russian, or Mexican stock markets compare in terms of valuation; the key is to keep an open mind when you’re looking for the best opportunity on the basis of fundamentals.

It’s true that more Americans own more non-U.S. stocks in their portfolios than at any time in history, reflecting the diminishing size of the U.S. stock market as a percentage of the global equity universe. (Today, U.S. stocks make up about slightly less than half of the $30 trillion in global equities, compared to about 60% two decades ago.) Unfortunately, too often those investments are made without thinking about relative valuation: Investors are using a bottom-up approach and deciding to pull money out of another investment and put it to work in, say, China’s hottest retail stock after reading a story about the growth of the Chinese consumer market. Instead, they should be thinking carefully and strategically about the Chinese stock market and the opportunities it offers in relation to the investment being sold to provide the cash to buy that hot stock. Where does the best valuation opportunity present itself? And where do valuations appear overstretched?

But with literally dozens of such disparate stock markets to sort through, how can an investor find a way to make a relative valuation decision? Forget about apples-to-apples comparisons; this is more like trying to compare cabbages to kiwis. Here’s where the venerable price/earnings ratio, or P/E ratio, comes into its own. I’m not suggesting that you allocate your entire equity portfolio to the ten markets with the lowest price/earnings ratios—that would be like using a howitzer to deal with an annoying mosquito. Indeed, if you rely only on the P/E ratio, you risk shunning higher-growth markets (which typically have higher P/E ratios) in favor of those that are more volatile and risky (which tend to have lower P/E ratios)—a far from sensible strategy.

At the same time, finding some way to compare the valuation of one asset class or category to another is vital because each dollar you invest in any one group of stocks or bonds is a dollar no longer available to invest elsewhere. So when you’re making the decision about what to do with that dollar, relative valuation becomes vital. Tune into Bloomberg radio or CNBC, and you’ll hear television pundits debating a particular stock’s valuation metrics and how such and such a price/earnings ratio or book value or dividend yield makes it cheap and thus attractive as an investment. But by itself, the assertion that Pfizer, for instance, is “cheap” tells you nothing, just as a price/earnings ratio, on a stand-alone basis, is completely useless. In deciding that Pfizer is cheap, what are those pundits measuring it against? The stock market as a whole? The average valuation of other pharmaceutical stocks? Pundits can gloss over this; you can’t afford to, because you need a compelling reason to buy (or sell) a particular security or asset, and that means understanding relative valuations. Are large-cap stocks more appealing than their small-cap counterparts and thus a good place to invest more of your portfolio? That is the kind of question the right metrics will help you to answer, just as they help me.

You also can’t rely on any single valuation tool in isolation. The ever-popular P/E ratio is the best example of this. Back in late September 1987, the S&P 500 stock index traded at 22 times actual earnings for the previous 12 months, while midway through the summer of 2002, it traded at 30 times earnings for the previous 12 months. Does that mean that stocks were a better bet in late September 1987 than they were in July 2002? Hardly. After all, the S&P plunged 30% in a single day in October 1987, whereas 2002 turned out to be the beginning of a long-lived stock market advance that would lead to a big jump in the S&P the following year. A superficial analysis looking only at absolute valuation would have ignored the factors that went into compiling price/earnings ratios. In 2002, for instance, P/E ratios were inflated artificially by the losses or tiny profits companies had reported in the midst of the recession (as well as the interest rate environment). It is interest rates that link earnings and prices; higher interest rates tend to drive P/E ratios lower, whereas in lower interest-rate environments, price/earnings ratios have room to grow. All things being equal, higher interest rates push the value of an income stream (whether bond income or dividend yield) lower.

A useful way to put the P/E ratio to work in the quest for the best valuation opportunities is to track the relative P/Es of one market compared to another over a period of time. If the P/E ratio of market A has tended to trade at a 10% premium to that of market B over the past 20 years, and now it trades at a discount, or at only a 5% premium, that tells me that market A may look relatively attractive on a valuation basis. As I write this, we are in the aftermath of a period during which the Russell 2000 Index (a great benchmark for small-cap stocks) has outpaced the S&P 500 for the past 5 years, generating nearly double the returns for investors. Not surprisingly, the P/E ratios of small-cap stocks trade at a significant premium to those of large-cap stocks; the kind of valuation disparity I haven’t experienced since 1997. Monitoring this comparative data led me to rebalance small- and large-cap stocks in favor of large-cap stocks in the second quarter of 2007. A wise move; in the 2 years that have followed, the S&P trounced the Russell 2000.

Of course, these valuation relationships are subject to change over time. Back in the 1980s, when what pundits today refer to as “emerging markets” were more typically described as “underdeveloped countries,” the valuation gap between the handful of stocks that traded on the fledgling stock exchanges in countries such as Mexico was wide enough to drive a truck through. Although that gap has shrunk over time as those emerging markets have become more numerous, more liquid, more diversified, and better regulated, trying to identify valuation opportunities based on history becomes more difficult. These days, the “risk premium” that had traditionally been applied to emerging market stocks has nearly vanished. Does that mean the emerging markets offer scanty investment opportunities, based on relative valuation? Perhaps—or maybe not. Perhaps it means that it’s time for us to revamp our ideas of how to view valuation tools that are based on historical patterns, and supplement them with other metrics. Momentum metrics prove particularly useful in gauging whether valuation data is off-kilter or not. If it ever really is “different this time,” we need to be flexible enough to adjust it. If your valuation metrics are steering you the wrong way, momentum will serve as a kind of guardrail, catching you before you drive off the cliff. (In other words, you’ll experience “negative momentum,” or lose money.) Momentum metrics are great insurance against massive and costly investment mistakes. Every once in a while, market relationships do change, and it truly becomes “different this time.” This view, in my opinion, does not apply to the emerging markets. They’re simply expensive.

Let’s say, however, that your initial valuation analysis has led you to favor adding income-oriented investments like bonds or real estate to your portfolio rather than stocks. Now you’ll need a different set of tools to measure the relative value of different parts of the global fixed-income markets. Despite my background as a bond investor, I have to remind myself that measuring bond yields holds its own set of challenges and perils. These bonds could be sovereign bonds issued by another country’s government, junk bonds sold to finance a corporate buyout, or a bond pegged to a package of assets such as mortgages or credit card receivables. Any of these categories could hold hidden risk for which I, as an investor, would want to be compensated. The key valuation consideration for all of these is how much they yield, and once again, that has to be measured on a relative basis. Typically, U.S. investors in search of some kind of benchmark against which to measure the yields of potential fixed-income investments will turn to the Treasury bond market, recognizing that Treasurys offer the combination of the highest credit quality (a triple-A credit rating) and greatest liquidity. Treasury bonds are also issued with a wide array of maturity dates, making it relatively simple to find a comparable Treasury security to use as a benchmark for nearly any competing fixed-income instrument.

Whenever you delve into the world of bond investing, you end up grappling with the issue of credit risk. What are the odds that the issuer of these bonds is going to be able and willing to keep making the interest payments as promised, and repay the principal when it comes due in 5 or 10 years’ time? In the world of the U.S. Treasury, those odds are pretty good. After all, the Treasury bills, notes, and bonds issued are backed by the “full faith and credit” of the U.S. government. Bond investors often joke that if the U.S. government ever defaults on these obligations, we’ll all have a lot more to worry about than simply losing money; such a default would signal a national catastrophe. That’s why professional investors use Treasury securities as a valuation benchmark and express the extra return they expect in exchange for the extra risk they take by venturing further afield in terms of the difference in yield between the Treasury and that new security: the yield spread. Let’s suppose that you’re contemplating investing in either a portfolio of emerging markets government bonds or a portfolio of bonds issued by U.S. companies with a mediocre, low triple-B credit rating. Both portfolios are made up of bonds that mature in 10 years, and, for the sake of argument, both carry the same credit rating. To figure out the better value, most investors will just calculate the current yield on both portfolios, and then compare those two figures to the yield on the 10-year Treasury. All things being equal, the portfolio that has the highest “spread” over the Treasury security is the one that offers the most attractive valuation: The bigger the spread, the higher the yield, and the more the investor is being paid for taking on the additional risk of venturing beyond the safe haven of the Treasury market.

The importance of credit risk was highlighted in the subprime crisis that began in the spring of 2007. As investors became more skittish, risk aversion ripped through the financial markets throughout the second half of that year and into 2008. By the end of November 2008, the crisis of confidence had escalated to the point that credit spreads resembled those seen only at the peaks of prior financial crises. Investors, it seems, were slapping a massive “distrust” premium on any investment that isn’t a Treasury-backed security. That, in turn, raised the bar on the kinds of returns that stocks must appear to offer investors. When yields on bonds—which rank above stocks in a company’s capital structure and thus offer a greater degree of security—soar to such generous levels, why take the extra risk of investing in stocks?

Some investors may be willing to invest in depreciating assets in exchange for a current income flow. For instance, an investor may decide to buy a video rental business despite the advent of Netflix and the ability to download movies directly from iTunes and other Internet sites. On the surface, it would seem that a video rental business has very little inherent value: At the very least, it’s a wasting asset as these new business models displace the neighborhood store. Anyone making this bet, therefore, needs to be confident that the income it generates will produce more than 100% of the return: It is unlikely that the business can be sold at a profit. Sometimes this kind of investment does make sense, but you need to make the right kind of valuation calculation. In another example, you might want to invest in an oil well, even though it will eventually run dry and the mineral rights on the land will have no value. But in this case, you know that when you try to determine the well’s investment value you need to focus on how much income that oil well will generate for you during its productive life. That may involve calculating how much oil is likely to be pumped out of the well (the well’s reserves), and then how much that oil may fetch on the open market. Then you can decide whether the valuation proposition makes sense: whether the income from the oil well will exceed its purchase price by enough to make the return attractive relative to other potential investments.

Other investments offer little in the way of income. That house in Miami that you’re thinking of buying? Unless it’s a holiday home that you will rent out for 6 months out of every year, it’s not going to generate any return until you decide to sell it. Similarly, an investor who buys gold as an investment will have to rely on metrics that rely only on capital appreciation; gold doesn’t pay any dividends or generate other income. Indeed, some kinds of gold investing actually cost investors money (in storage and insurance costs for bullion, for instance), so the potential capital appreciation has to be large enough to offset that extra expense. Another example is venture capital funds, or an investment in promising but still-risky biotech companies. In both cases, returns will come if, and only if, the ideas and concepts are proven over time. Access to capital may become a “valuation fundamental”; so, too, may the Food and Drug Administration’s decision whether to grant approval to a new drug.

Your job as an investor is to go beyond looking at the price you must pay for an investment you are contemplating and find a way to establish a value on it. Then, you must compare that value to the prevailing market price, as well as to the values and prices of other investment options. In some markets, that process will be relatively straightforward thanks to the existence of well-established metrics. In other cases, you might have to be creative. The objective is to develop a set of valuation metrics that can serve as a solid foundation for your entire investment process. If you don’t understand how valuation metrics work and how to use them, you will hinder your own ability to assemble all the pieces of the investment puzzle and decipher what it is telling you.