A Market Derived Valuation Model

When it comes to valuing the market should an investor start with his/her conclusions and then see if the market is in agreement (intrinsic value to market value stuff)? Or should an investor start with the market’s conclusion (in the form of its current price) and then attempt to identify what would have to be produced (in the form of projected future earnings) to justify the current price?

To accomplish the former, all one has to do is turn to the media and give a listen to the myriad of talking heads pontificating on what should be by starting with what they perceive is the message of the economy (or industry or company) and then debating their conclusions with that reached by the market.

To accomplish the latter, an investor would start with the message of the market and then seek to match it with an appropriate set of inputs (such as earnings, growth rates, and a discount factor) to determine what inputs would be necessary to match the current price. To do this, an investor would need a process by which the message of the market (in the form of its current price) is the start point from which the justification for that message must be acquired. Allow to illustrate how this could work.

The accompanying table* starts with the message of the market in the form of its current price. In this case, we use the S&P 500. That price level is then inserted into a simple, yet elegant valuation model that lists what earnings would be needed to justify current price levels. Next, an important part of the equation is the discount rate is used to bring the future cash flows (operating earnings) back to their present value**. Then, the current price is projected 12 months ahead. The final step is to divide an assumed P/E ratio into the forward market price to produce a calculated earnings level to justify that future price. What you have is what subscribers to my newsletter see every week – a market derived valuation model that seeks to identify what earnings and P/E might “match” the message of the market.

Each week I plug in the current price and then move the earnings numbers up or down to produce the market derived fair value that comes close to matching the current price. What this does is help me understand the expectations of the market that are built into its current price and the appropriate earnings necessary to justify that price. From this point, I can then decide if I am in agreement with the conclusions reached or beg to differ.

Investment Strategy Implications

One can obviously argue with several elements of the valuation model. For example, one might disagree with the time period used. Another might conclude that some of the assumed inputs, such as the discount rate (which is also the assumed required return for large cap stocks), are inappropriate. Then there is the use of a terminal value, the time period involved (just over 3 years hence), and its inputs (4% growth rate).

While valid, this is beside the point in the sense that by placing the market’s implied valuation via its current price into a valuation model that attempts to match the market’s implied value with the appropriate earnings necessary to justify the current market price enables an investor to challenge or accept the market’s conclusion (via its current price).

You can choose your metaphor - chicken or the egg, cart before the horse. Sometimes, focusing on the message of the market first enables one to hear more clearly.

*click image to enlarge
**Note: The growth rate is calculated as a result of the earnings inputs and the discount factor. This is important as we want to keep the focus away from our opinion about what should occur and on what the market says will occur.