Submitted by
Fast
Graphs
as part of our
contributors program
.
As investors, we do not believe in forecasting stock markets or
stock prices on individual stocks. Instead, we approach investing
as the process of calculating intrinsic value based on
fundamentals. To us, the most important fundamental to be
considered when evaluating the True Worth™ of a market or a common
stock is earnings. Therefore, it's important that the reader
understands that this article is offered as a mathematical
calculation of what the S&P 500 is actually worth based on
earnings. The reason we believe this to be important is because we
also believe that any deviations from fair value will ultimately
self-correct.
As we will soon illustrate, in the short run the stock market
has a penchant for grossly mispricing common stocks and broad
indices. When this is occurring, it is extremely valuable and
important for investors to be able to recognize extreme and/or
erroneous valuations when they manifest. It is also our contention
that the calculation of fair valuation is both practical and
achievable. In contrast, we further believe that attempting to
forecast short-term market or price movements to be an exercise in
futility. When irrational behavior is rampant, there is no logic
that can be applied.
Our point is, making investment decisions based on valuation is
a sound exercise that will bear fruit long term. As already stated,
in the shorter run prices can go beyond fair value or below it.
But, inevitably stock prices will seek intrinsic values. Therefore,
we believe that intrinsic value is something that can be trusted,
whereas stock price volatility cannot. Admittedly, this is not as
easy as we may be making it appear. The trick lies in forecasting
future earnings as accurately as possible. The better you can do
that, the more accurate your long-term forecast will be. But, once
again, we contend that forecasting earnings can be done more
accurately than attempting to forecast short-term price movement.
On the other hand, this is easier to do on an individual company
(business), than it is on a broad index like the S&P 500.
Historically Normal Valuations
When writing articles such as this, many authors tend to
gravitate towards statistical references. And, although there can
be value found through statistical analysis, it's also very easy to
draw erroneous conclusions. With that said, there is a
preponderance of historical data, and calculations based on that
data, that the historical normal PE ratio for the S&P 500 is
15. However, even more importantly, we believe that there is a
rational mathematical explanation for why a PE of 15 represents the
proper average valuation for most companies, and therefore, an
index like the S&P 500.
A detailed explanation of the mathematical validity of the PE
equals 15 thesis is beyond the scope of this article. However, a
brief explanation of the underlying principles should suffice. The
normal PE of 15 is based on the reality that a stream of income
generated from an investment is worth more than one times earnings.
This is true even if the future income stream does not grow. In
other words, if we assume, for example, an interest rate of 8.5% on
a bond (of course bond yields are much lower than that today), we
would discover that the bond is trading at approximately 12 times
interest. Since the future income stream on a bond is fixed, it
only stands to reason that a growing income stream, such as found
on a stock, should also command a multiple greater than one,
adjusted for risk.
That number has historically hovered around a PE of 15, because
this represents an earnings yield of 6%-7%. This number is very
close to the long-term historical returns that stocks have
delivered on average. Admittedly, we have not provided significant
proof of our statement based on what is written above. Instead, we
are simply offering some hints as to how the normal PE of 15 can be
justified. Put another way, there is a lot of research that
suggests that the normal PE ratio for the S&P 500 over the past
100-plus years is 15. Additionally, there is further research that
indicates that the normal PE ratio for the S&P 500 over the
past 20 years has been closer to 20 (19.3 on our graph below). Our
analysis, and a quick glance at the earnings and price correlated
graph below, indicates that this higher than normal PE over the
past 20 years can be mostly attributed to excessive
overvaluation.
The S&P 500 via F.A.S.T. Graphs™
When looked at through the lens of our
F.A.S.T.
Graphs™
research tool, we can test theory and see how it applies in the
real world. The following earnings and price correlated graph of
the S&P 500 since calendar year 1994 tells some interesting
stories. Perhaps the most interesting story is how the chart
depicts two calculated PE ratios that equal the 20-year historical
normal PE of approximately 20 (19.3), and the longer-term normal PE
ratio of 15. In the first case, the PE of 20 (blue line with
asterisks) was determined as the computer calculated the trimmed
mean (outlier highs and lows trimmed to eliminate skewing) PE ratio
for that time period. In the second case, the PE of 15 was
determined by applying a widely-accepted formula for valuing
businesses to the EPS growth rate of 7.5% for the S&P 500 since
1994.
The important takeaway from reviewing the earnings and price
correlated graph is the visual depiction of how statistics can
mislead. Clearly, the black monthly closing stock price line often
deviated significantly above and below the trimmed mean PE ratio of
20. Therefore, even though it is statistically accurate to state
that the normal PE over this time frame was 20, a quick visual
shows how often that was not true. As previously stated, we believe
that the graph vividly illustrates the meaning of the phrase
"irrational exuberance." On the other hand, we believe the graph
further vividly illustrates how the black monthly closing stock
price line continuously attempted a reversion to the mean towards a
historically significant normal PE of 15. The reader should note
that although all data is plotted, when we draw a graph of 20
years, we only type in every other year's data because of space
restraints (Note the asterisks by the years at the top of the
graph).
Conclusions
In conclusion, there continues to be a lot of opinion and
speculation regarding whether the S&P 500, or the stock market,
or stock prices in general are overvalued or not. From the
perspective of earnings justified valuations as depicted in the
graph above, at 14.1 times earnings, it is arguable that the
S&P 500 is slightly undervalued at these levels. Moreover,
taken directly from their website, the current forecast for
operating earnings of the S&P 500 by Standard & Poor's
Corp. is $101.33. If this forecast is accurate, this would imply a
year-end fair value for the S&P 500 of approximately
1519.40.
Mathematically, it would indicate that the S&P 500 has
approximately another 7.52% upside by year-end. Once again, this is
not a prediction, instead this is a mathematical calculation based
on applying a normal PE ratio of 15 to the current earnings
expectations of the S&P 500. It is our intention to provide an
updated F.A.S.T. Graphs™ on the S&P 500 periodically. If
forecasts change, then so will the anticipated valuation
expectations.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
Disclaimer:
The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment advisor as to the suitability of
such investments for his specific situation.