Tuesday, January 12, 2010

Doing the Valuation Math

Now that my market forecast events have begun (with NYSSA's event last Thursday), it's time to do a little valuation math for the year ahead. So, based on the initial comments heard at last week's event and elsewhere, here you go:

18 times $80 (S&P 500 operating earnings for 2010) = 1440.
1440 minus a present value discount (12%) = 1267

This is the bulls’ case for why stocks should go higher this year – an above historical average P/E times a robust earnings growth for 2010 minus an historical average discount rate (bringing the future value back to the present*) equals a most profitable year.

The valuation debate is a paradox – simple yet complicated. Simple in that the formula is rather easy to compute. Complicated in that the social science known as investing involves numerous variables, many of which are highly subjective. For example, the P/E used in a valuation model is based on the views of the investor for the economic and market times of the moment and the near future. In the current case, the bulls would argue that an above average P/E is appropriate for the current and near future because history says so – low inflation + robust economic growth + strong corporate balance sheets = above average P/Es. Exactly what level above the historical average P/E (which happens to be 15) is the subjective wiggle room and a key area of the valuation debate. Then there is the earnings number.

$80 operating earnings for the S&P 500 for 2010 is the best case number I am hearing of late. Of course, this number is open for debate. The final two components that investors might want to ponder doing the valuation math involve the discount rate and the time period.

In the above illustration, I used the historical average return for large cap stocks, which has often (but not always) been 12%. Some would argue that 10% (or lower) is a more appropriate going forward expected return for stocks given the slow growth environment envisioned for the next several years for advanced developed economies. Then there is the time period one discounts the future value. In the above case, I use 12 months. Some might argue things are far to dynamic and a 6 month discounting time period is more appropriate.

Investment Strategy Implications

Wherever you fix the fair value of today’s market, the valuation math always needs to be done as it provides the return context for an asset. For what it’s worth, I think these times are extraordinary and do not warrant an above average P/E (which signifies a below average risk climate). Rather, I would argue the uncertainty factor for 2010 is considerably higher than the bulls believe, despite the prospects of a robust earnings period for the large cap, multinational companies that populate the S&P 500. Risks in areas broad (e.g. geo political, US domestic political, developed economies’ internally generated growth) and specific (e.g. sector specific issues such as those facing the financial services and healthcare industries, sustainability of Chinese growth, regulatory change) are abundant and should be ignored at one's financial peril.

All of this leads to the more prudent conclusion that an average P/E times a moderately higher earnings growth rate is appropriate. In other words,

15 times $74 = 1110
1080 minus 12% = 977

Therefore, at today’s price of 1140 the market is currently 14% overvalued.

Liquidity driven markets have a funny way of producing overvalued markets. And an even funnier way of producing justifications for just about any fantasy valuation levels one wants to concoct. At least for a while.

*Note: It is important to remember that on any given day stocks sell at a discount to their expected future value. Therefore, today’s price is always a discount to where stocks should be in the near future.

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