On Domestic vs. International Equity Valuation

When deciding whether to overweight US vs overseas equities, looking to PE ratios are helpful. The S&P 500 trades at about 23 times earnings while the MSCI All Country World ex-US Index trades cheaper at about 19. This, on the surface, would give you motivation to ship your dollars across borders for greener pastures. While Occam’s Razor may cut it in most overtly complicated situations, there is more at play here. What if non-US equities usually trade at a discount to their domestic counterparts? Well, they do, and we must account for that. While we are in the mood of tearing down closely held conventional wisdom, why not ask another question? One like, what if the Price to Earnings ratio is not as useful as hoped? Well, it’s not- at least in my calculations.

The Enterprise Value / EBITDA ratio is the one we’ll roll with, primarily because that is the only other data I could get my hands on, and, luckily, it proved more telling. Well enough. EV, or Enterprise Value is the value of a business once cash is removed. The cash is removed because it can be used to pay down debt. Now, EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This is an attempt to come closer to operating earnings than the bottom of the income statement. One could call this the PE ratio for a private concern.

Here is the thesis: when the spread between the S&P 500 and MSCI ACWX narrows, US stocks should outperform, and vise versa. 

Over one year this proved useless, but over longer time horizons the difference in valuation multiples has some explanatory power. With monthly data stretching from 1995, seven years proved most useful with an r^2 of 0.37.

 

SPX-MXWDU Spread Chart.png

 

At year end, the spread between the two indices came in at 3.2. This is wider than the median of  1.4. Because the US is more expensive than the median spread to international equities, it is expected that a reversion to the mean should take place.  This does not mean that is necessarily will.

 

In any case:

This spread yields an expected annualized performance differential of -5.4% over the next seven years. 

 

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2 thoughts on “On Domestic vs. International Equity Valuation

  1. Pingback: Equity Risk Premiums Across The Globe – The State of Capital

  2. Pingback: On Domestic vs. Emerging Valuation – The State of Capital

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