U.S. EQUITIES: VALUATION & FUNDAMENTALS

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1 LM Market Insight: U.S. EQUITIES: VALUATION & FUNDAMENTALS APR 2016 THIS MATERIAL IS ONLY FOR DISTRIBUTION IN THOSE COUNTRIES AND TO THOSE RECIPIENTS LISTED. PLEASE REFER TO THE DISCLOSURE INFORMATION ON THE FINAL PAGE. IN THE UNITED STATES -

2 Are current equity valuations stretched? S&P 500 valuation measures 3/31/2016 Average* Price/Earnings Price/Book Price/Cash Flow Price/Sales Enterprise Value/EBITDA S&P 500 Earnings Yield 4.88% 5.39% S&P 500 Dividend Yield 2.19% 1.85% 10yr Treasury Yield 1.77% 4.09% Sources: Bloomberg, S&P Dow Jones Indices and S&P Shiller Market Data, as of 3/31/16. March 2016 P/E is based on 1Q16 earning estimates and index price as of 3/31/16. The forward P/E is based on quarterly S&P earnings estimates for December This information cannot be guaranteed and all liability is disclaimed on S&P s own behalf and on behalf of its information providers for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. * The Price/Earnings average is based on the quarterly operating P/E since December 1988; all others are 20-year averages. Please see pages for important disclosures and definitions of terms Page 2

3 S&P 500 is no longer cheap on a P/E basis S&P 500 P/E ratio: trailing 12 months and forward basis 40 S&P 500 Cyclically-Adjusted Price Earnings (CAPE) Ratio Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Recession P/E Forward P/E Dec-14 Dec Dec-56 Mar-62 Jun-67 Sep-72 Dec-77 Mar-83 Jun-88 Sep-93 Dec-98 Mar-04 Recession CAPE AVG Jun-09 Sep-14 The S&P 500 P/E ended March 2016 at 20.5x above its average of 18.7x since December forward P/E was15.2x as of 3/31/16, based on estimated earnings for calendar year The CAPE ratio ended March 2016 at 25.6x vs. a long-term average of 19.6x. 1 Note: some argue this measure now overstates valuation because of accounting changes that may have introduced significant distortions into the calculation. Sources: S&P Dow Jones Indices and S&P Shiller Market Data, as of 3/31/16. March 2016 P/E is based on 1Q16 earning estimates and index price as of 3/31/16. The forward P/E is based on quarterly S&P earnings estimates through December This information cannot be guaranteed and all liability is disclaimed on S&P s own behalf and on behalf of its information providers for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Please see pages for important disclosures and definitions of terms Page 3

4 Other popular valuation measures tell a similar story S&P 500: Price-to-Book & Price-to-Sales S&P 500: Price-to-Cash Flow & EV-to-EBITDA Mar 96 Mar 98 Mar 00 Mar 02 Mar 04 Mar 06 Mar 08 Mar 10 Mar 12 Mar 14 Mar 16 Mar 96 Mar 98 Mar 00 Mar 02 Mar 04 Mar 06 Mar 08 Mar 10 Mar 12 Mar 14 Mar 16 P/B Ratio P/S Ratio Avg P/B Avg P/S P/CF Ratio EV/EBITDA Avg P/CF Avg EV/EBITDA At the end of March 2016: Price-to-book was 2.8x, below its 20-year average of 3.0x. Price-to-sales was1.8x, above its 20-year average of 1.6x. Price-to-cash flow was 10.9x, below its 20-year average of 11.6x. At the end of March 2016: Based on Enterprise Value - to - EBITDA, the S&P 500 traded at 13.1x, above its 20-year average of 11.1x. Source: Bloomberg, as of 3/31/16. See page 9 for index definition. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Please see pages for important disclosures and definitions of terms Page 4

5 From an income standpoint, stocks compare favorably with Treasuries S&P 500 dividend per share and payout ratio $45 80% S&P 500 earnings and dividend yield; 10yr UST yield 10% $40 $35 70% 60% 8% Dividend per share $30 $25 $20 $15 $10 50% 40% 30% 20% Dividend payout ratio Yield (%) 6% 4% 2% $5 10% 0% % Mar-96 Mar-00 Recession Mar-04 Mar-08 Mar-12 S&P 500 Earnings Yield Mar-16 S&P 500 Dividends (left axis) S&P 500 Dividend Payout Ratio (right axis) 10yr UST Yield S&P 500 Dividend Yield Dividends have experienced solid growth. Record high dividend per share of $42.62 in March 2016, but at 38% the payout ratio is below its historical average of 48% since 1950 High corporate cash suggests potential for continued dividend growth Stock yields compare favorably to UST yields As of March : S&P 500 earnings yield = 4.9% S&P 500 dividend yield = 2.2% 10yr UST yield = 1.77% Sources: S&P Dow Jones Indices, S&P Shiller Market Data and Bloomberg. Dividend per share data, S&P 500 earnings yield data, S&P 500 dividend yield data and 10-year UST yield data as of 3/31/16. Dividend payout ratio for 12/31/2015 and 3/31/16 is based on S&P estimates and not final earnings, which aren t available yet. This information cannot be guaranteed and all liability is disclaimed on S&P s own behalf and on behalf of its information providers for any damages or losses arising from any use of this information. See page 9 for index definition. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Please see pages for important disclosures and definitions of terms Page 5

6 Fundamentals could provide support for prices S&P 500 Operating Earnings, actual and estimated S&P 500 profit margin estimate is $ Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 Mar 96 Mar 98 Mar 00 Mar 02 Mar 04 Mar 06 Mar 08 Mar 10 Mar 12 Trailing 12 month profit margin Mar 14 Mar 16 Recession S&P Annual Earnings Estimated Recession Profit Margin Average After a record recovery from the last recession, earnings growth has stalled; rebound seen in 2016 and 2017 As of 3/31/2016, S&P 500 earnings growth for calendar year 2016 is estimated to be up 17.6% following an estimated decline of 11.1% in calendar year As of 3/31/2016, S&P 500 earnings were expected to grow to $ by the end of 2017, which would represent a 15.1% gain from 2016 estimates.. S&P 500 profit margin is down from recent peak, but still high Profit margin was 8% as of 3/31/16, down from a high of 9.6% in September 2014, but still above 6.4% average since Sources: S&P Dow Jones Indices and Bloomberg, as of 3/31/16. This information cannot be guaranteed and all liability is disclaimed on S&P s own behalf and on behalf of its information providers for any damages or losses arising from any use of this information. See page 9 for index definition. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Please see pages for important disclosures and definitions of terms Page 6

7 Sales have slowed, but debt is down and free cash flow is up since the financial crisis S&P 500: revenue per basic share $1,400 $1,200 $1,000 $800 $600 $400 $200 S&P 500: total debt and free cash flow Total debt, billions $1,400 $1,200 $1,000 $800 $600 $400 $200 $140 $120 $100 $80 $60 $40 $20 Free cash flow per share Mar 96 Mar 00 Mar 04 Mar 08 Mar 12 Mar 16 Mar-96 Mar-00 Mar-04 Mar-08 Mar-12 Mar-16 Recession Revenue per share Linear (Revenue per share) Recession Total Debt Free Cash Flow Per Share Sales were slower to rebound than corporate profits and earnings. following the recession and have recently stalled Sales growth could accelerate if the recovery broadens, particularly given pockets of pent-up demand. Total debt remains well below pre-recession levels Free cash flow is well above pre-recession levels Source: Bloomberg, as of 3/31/16. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Please see pages for important disclosures and definitions of terms Page 7

8 Economy-wide, after-tax corporate profits have rolled over, but corporate cash was near a record high US After-tax corporate profits $2,000 US corporate cash $2,500 $1,600 $2,000 Billions $1,200 $800 Billions $1,500 $1,000 $400 $500 Dec-95 Dec-99 Dec-03 Dec-07 Dec-11 Dec-15 Dec-95 Dec-99 Dec-03 Dec-07 Dec-11 Dec-15. Source: Bloomberg, as of 12/31/15, latest available. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Corporate profits are represented by domestic non-farm non-financial corporate business liquid assets. Please see pages for important disclosures and definitions of terms Page 8

9 Fundamentals matter more as valuations rise Investors appear cautious about higher valuations Outflows from long-term domestic equity funds may reflect elevated skepticism That s unusual for market tops, which have generally been associated with investor exuberance While a fairly valued market implies fewer outright bargains, it does not mean there are no attractive opportunities in today s market That underscores the potential value of active stock pickers who focus on the fundamental strengths and weaknesses that differentiate individual firms Domestic equity funds: 12 month cumulative net new cash flow Billions $50 $50 $100 $150 $200 $250 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar 14 Mar 15 Mar 16 Source: Investment Company Institute, as of 4/6/16. March 2016 flows are estimated as of week ended 3/30/16. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Please see pages for important disclosures and definitions of terms Page 9

10 Investment risks: The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. Common stocks generally provide an opportunity for more capital appreciation than fixed-income investments but are subject to greater market fluctuations. Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies. Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. Active Management does not ensure gains or protect against market declines. Yields and dividends represent past performance and there is no guarantee they will continue to be paid. Please see pages for important disclosures and definitions of terms Page 10

11 Definitions of terms: The cyclically adjusted price-to-earnings ratio (CAPE) is defined as price divided by the average of ten years of earnings, adjusted for inflation. Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price. The earnings yield is the earnings per share for the most recent 12-month period divided by the current market price per share. It is the inverse of the P/E ratio. EV / EBITDA equals a company's enterprise value divided by earnings before interest, tax, depreciation, and amortization. It measures the price (in the form of enterprise value) an investor pays for the benefit of the company's cash flow (in the form of EBITDA). The forward P/E ratio is a stock s (or index s) current price divided by its estimated earnings per share (or estimated index earnings), usually oneyear ahead. Free cash flow (FCF) is measure of financial performance calculated as operating cash flow minus capital expenditures. It represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value. Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time. Operating earnings is profit earned after subtracting from revenues those expenses that are directly associated with operating the business, such as cost of goods sold, administration and marketing, depreciation and other general operating costs. The price-to-book (P/B) ratio is a stock's price divided by the stock s per share book value. The price-to-cash flow (P/CF) ratio is a stock's price divided by the amount of cash generated per share by a company's operations. The price-to-earnings (P/E) ratio is a stock's price divided by its earnings per share. The price-to-sales (P/S) ratio is a stock's price divided by its sales per share. The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Please see pages for important disclosures and definitions of terms Page 11

12 Important Information All investments involve risk, including possible loss of principal. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. 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