It can be helpful to evaluate both fundamental and relative equity valuations, with a few caveats.
Evaluating equity exchange-traded funds for tactical investments is not unlike the process of selecting individual stocks. Equity ETFs are, after all, baskets of stocks. So naturally, we can apply many of the same valuation techniques we use when evaluating individual stocks.
A valuation-based view of the world is helpful when making all of your investment decisions. Even the most avid proponents of passive investing estimate expected returns for various asset classes when establishing their strategic asset allocation. Active investors with more of a tactical bent are likely to rely on valuation metrics to a greater extent. Investors in this more active camp assume that over a given period of time the market gets asset prices wrong but eventually corrects itself as new information becomes available.
Let's take a closer look at the two most common valuation methods: fundamental valuation and relative valuation. Whether your strategy (or personal preference) favors fundamental or relative valuation, it can still be helpful to check both methods. Scrutinizing your investment ideas from every possible angle will only help bolster your confidence.
Discounted cash flow analysis forms the basis of fundamental valuation. With the DCF approach, the value of a stock is not how much someone else thinks it is worth or is willing to pay for it. Rather, the value of a stock is the present value of its expected future cash flows, which are discounted back at a rate that reflects the uncertainty of those cash flows.
As with all models, the information you get out is only as good as the information you put in. Making accurate, or useful, forecasts relies on using sound assumptions. This requires an intimate knowledge and familiarity with a company's business model as well as the competitive dynamics of the given industry and the regulatory environment surrounding it. If you're feeling intimidated, don't worry.
Morningstar has a team of 125 equity and credit analysts who conduct fundamental analysis and derive fair value estimates for more than 1,800 companies worldwide. Think of it as your very own army of fundamental equity research analysts. Because these data can be aggregated to the fund level, we can form an estimate of intrinsic value for equity ETFs*, which are simply worth the sum of their constituent parts.
Access to Morningstar's vast equity research resource gives us a unique advantage in that we can use the research to form thematic ideas about which sectors appear attractive and which sectors investors should avoid. The following table highlights the S&P 500 sectors, ranked from lowest price/fair value to highest.
Currently, Morningstar analysts believe the market is just slightly undervalued. After the beating it took amid plunging oil prices, energy looks like the cheapest sector. At the other end, health care is currently trading at a slight premium to Morningstar analysts' estimate of fair value following a string of strong performance.