Wednesday, June 22, 2011

The Fine Art of Valuing the Stock Market

When I appear on* today with Tracy Byrnes, one of the items I hope we discuss is the accompanying valuation table (click image to enlarge).

Then are several ways to employ this table but perhaps the most useful way is to:

1 - Start with today's price level for the S&P 500.
2 - Then find those P/E and projected operating earnings in present value section (right side) of the table that roughly match today's price.
3 - Now look at the future value (left side) of the table. That is where the market projects it will be 12 months hence.
4 - Decide if you agree or disagree with the market's conclusion.
5 - Let the debating begin.

Valuation is a subjective process that attempts to bring into the equation what investors forecast earnings will be AND what they (and this is key) believe the appropriate P/E that should be applied to the forecasted earnings. There are many factors to be taken into consideration. For example, an above average P/E (say 17) can mean:

1 - It is appropriate in terms interest rates, growth rate of earnings beyond the next 12 months, quality of earnings, and degree of risk (global macro), Therefore, the current level of the market is far too pessimistic at 17 times $85.
2 - It is appropriate as earnings will tumble but, for a variety of additional reasons, the P/E will anticipate that the earnings decline will be short lived.
3 - It is inappropriate as rates will rise, risk is and will be far greater in the not too distant future, and the growth rate in earnings will disappoint. Therefore, a lower P/E is more appropriate.

And that's only a start. Other P/E and earnings mixes lead to other combination of factors.

What the accompanying table provides is a way to reverse engineer that process by starting with the current level of the market and then identifying what the current level suggests.

Therefore, taking yesterday's close, the following P/E and operating earnings closest are:

14 x $102 (average of $100 and $105)
15 x $95
16 x $90
17 x $85

As step #5 says, "let the debating begin".

*To view the 12 noon eastern time appearance, click here.

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