S&P 500 Index Earnings Type	Annual Earnings on Index	P/E Ratio at 770 S&P	Earnings Yield
Actual latest year (trailing four quarters) GAAP earnings	$26.16	29.4	3.4%
Latest year "operating"  earnings (removes "unusual" items)	$54.60	14.0	7.1%
Forecast forward GAAP earnings for the next year (next four quarters)	$32.41	23.8	4.2%
Forecast forward operating earnings for the next year (estimates summed by individual company)	$66.61	11.6	8.6%
Forecast forward operating earnings for the next year (estimate for the group of companies)	$48.15	16.0	6.3%
For Comparison here are S&P 500 Earnings in prior years:
2007 Actual GAAP Earnings	$66.18
2006 Actual GAAP Earnings	$81.51
2005 Actual GAAP Earnings	$69.93
2004 Actual GAAP Earnings	$58.55
2003 Actual GAAP Earnings	$48.74

The above numbers are all straight from the source, Standard and Poors at: http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

When you ask the "simple" question of "what is the earnings on the S&P 500?" index or "what is its P/E ratio?" you are given a number of quite different answers. We can help you fully  understand the different answers.

Standard and Poors itself in its "The Outlook" publication focuses on the forecast 2009 (called  forward) operating earnings scenario, summed by individual which is the highest earnings number and lowest P/E in the table above. I find that to be overly aggressive as it ignores unusual losses. (Surely on a group of 500 companies a certain amount of so-called "unusual" losses is to be expected and should not be ignored). Also these company-by-company forecast operating earnings are higher than the forecast for the group of companies as a whole and this indicates an upward bias in the earnings forecast.

As of  February 20, 2009, the S&P 500 index was at 770 and had a Price Earnings Ratio ("P/E") of  (an unattractively high) 29.4 based on actual trailing reported earnings and a current Dividend yield of 3.20%.  The trailing P/E based on operating earnings (eliminates unusual one-time items) was considerably more attractive, but still not low, at 14.0.  The forward S&P 500 P/E ratio based on projected reported GAAP earnings in the next 12 months was unattractively high at 23.8. The forward P/E based on forecast or forward operating earnings in the next 12 months (eliminates unusual one-time items) is moderately high at 16.0 (based on an overall index forecast) and impossibly optimistic at 11.6 based on the summation of individual forecast operating earnings for the 500 companies.

Most analysts might focus on forecast operating earnings for the index as a whole (P/E of 16.0) as the best estimate since it eliminates unusual gains and losses and is future oriented.

Given that projected earnings tend to be optimistic and to ignore "unusual" losses, I normally prefer to use the actual trailing P/E, or equivalently the actual trailing GAAP earnings level.. However, at this point in time both the trailing and forward P/Es based on actual and forecast reported S&P 500 earnings have been driven higher due to an extremely large unusual losses at a number of large companies including General Motors and many of the large banks.  In this case the the unusual losses were very large.  A normalized view of S&P 500 earnings is needed. The long term average of S&P 500 index earnings in dollars relation to GDP in billions is 0.49%. Therefore based on 2008 GDP of 14,281, I calculate a normalized (essentially a non-recession level) view of current S&P 500 earnings as $70. This would imply the adjusted P/E of the S&P 500 is currently about 770/70 = 11.0.

This assumption of a a normalized or starting earnings level of $70 is equal to the 2005 actual GAAP earnings, lower than the peak earnings of $81.51  and moderately higher than the 2007 level of $66.  It is important to understand that this starting earnings level is a very major determinant in our calculation of the fair value of the S&P 500 index.

The S&P 500 index represents a portfolio of 500 stocks. For each $770 (the index value)   purchased, the underlying companies in the portfolio are earning an adjusted or normalized earnings level of $70 and currently pays an annualized dividend of $770 * 0.0320 = $25. 

It is important that we not base the analysis on an unrealistic level of S&P 500 earnings such as might be caused by a one-time peak in earnings or unusual losses.

When we buy the S&P 500 index, we can therefore think of it as being an investment or "stock" that (as of February 20, 2009) costs $770 and currently earns (on an adjusted or normalized basis) $70 per year and pays a current dividend of $25 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of $770.

We know that the S&P 500 index was at 770 on February 20, 2009. We can estimate what the S&P theoretically "should" be  trading at based on the value of its current earnings and dividends and the projected growth in those earnings and dividends. This intrinsic value approach calculates the value of the projected earnings and dividends for a ten year period and then assumes that the index is sold at some projected future P/E ratio.

In addition to the beginning earnings and dividend level, three additional factors are required to calculate the fair value at which the S&P 500 should be trading at. These are, 1. The forecast average annual growth rate in earnings and dividends over the next ten years. 2. The forecast P/E ratio at which the S&P index will be trading in ten years time. 3. The estimated rate of return required by investors.

The S&P 500 portfolio average earnings should (in the longer term) grow at a rate close to the growth rate of the U.S. economy in nominal (after inflation) terms. I believe a prudent estimate for this growth rate is  4% to 6% and I would focus on 5%.  We have a short article that both explains why (quoting Warren Buffett) and also demonstrates that earnings tend to grow at about the same rate as nominal GDP growth in the long run.

The following graph illustrates that S&P 500 earnings have trended up at about the same rate as GDP growth (although slightly lower) over the long-term, although certainly with substantial volatility around the trend in individual years and over short periods of years.

This graph above also clearly illustrates that the U.S. GDP (In nominal dollars, not inflation adjusted dollars)  has trended up steadily and has never failed to grow over say a three year period, except in the case of the depression. Those who are betting on a major decline in U.S. GDP and/or betting on a permanent decline in earnings on the S&P 500 index are betting against history.

The average for the S&P 500 P/E ratio since 1935 is 15.6. But the average since 1988 has been 23.15. However the Justifiable P/E changes with earnings expectations and the market's required return on equities. I have conservatively calculated that the current Justifiable P/E is in the range of only 16.0 to 14.3, even with today's low interest rates.  However, I have given some weight to the much higher historical figure since 1988. The range used in our table below is 13 to 17.

I would estimate that a minimum (pre-tax) return required by stock investors is in the range of 7% to 9%. The higher return required by investors then the lower the price or level that investors should be willing to pay for the index today, all else being equal. Given the recent credit crisis, it may be prudent to assume that investors require a return of 8 or 9% rather than the 7% which arguably investors appeared to be accepting previously when they had bid stock prices up to higher levels.

The following table calculates the value that the S&P 500  will be  at in ten years given various forecasts for the earnings growth and given various scenarios for the forecast P/E ratio that will apply at that time. The last column of the table then shows the fair or present value that we should be willing to pay today for the cash flows that would result from ten years of dividends plus the assumed cash from selling the index in ten years time. The present value is calculated based on various scenarios for the required return or discount rate.

 

S&P 500 Current Annual Earnings Estimate	S&P 500 Current  Annual Dividends	Earnings and Dividend Growth forecast	S&P 500 P/E forecast in 10 years	Resulting S&P 500 index in 10 years	Required Return	Resulting S&P 500 index Fair Value Today
70	25	4.0%	13	1,347	7%	899
70	25	4.0%	15	1,554	7%	1,005
70	25	4.0%	17	1,761	7%	1,110
70	25	4.0%	13	1,347	9%	764
70	25	4.0%	15	1,554	9%	851
70	25	4.0%	17	1,761	9%	939
70	25	4.5%	13	1,413	7%	938
70	25	4.5%	15	1,631	7%	1,049
70	25	4.5%	17	1,848	7%	1,159
70	25	4.5%	13	1,413	9%	797
70	25	4.5%	15	1,631	9%	889
70	25	4.5%	17	1,848	9%	980
70	25	5.0%	13	1,482	7%	979
70	25	5.0%	15	1,710	7%	1,095
70	25	5.0%	17	1,938	7%	1,211
70	25	5.0%	13	1,482	9%	831
70	25	5.0%	15	1,710	9%	927
70	25	5.0%	17	1,938	9%	1,024

Conclusions

Given my assumed current normalized earnings level of $70and the actual dividend of $25, by changing the expected earnings growth rate, the return required by the investor and the assumed P/E ratio that will apply in ten years I can calculate that today's S&P 500 index should be anywhere from 764 (assumes that our starting earnings level of $70 is appropriate, that the market P/E falls to 13, earnings grow at only 4% annually and equity investors require an expectation of making 9%) to 1,212 (assumes our starting earnings level of $70 is appropriate, a terminal market P/E of 17, earnings grow at 5% and investors only require an expectation of earning 7% on equities).

My own fair-value estimate is 969 based on the average of the two high-lighted rows  This assumes that investors require a minimum 8% expected return, that the S&P earnings and dividend will grow at 4.5%  (3% GDP growth plus 1.5% inflation) and that the long run S&P 500 P/E ratio is 15. Higher S&P 500  index values are implicitly assuming that the representative starting earnings level is higher than $70, that earnings growth will exceed 4.5% annually, that the justifiable long-run P/E exceeds 15, and/or that investors require less than a 8% (pre-tax) return.

Our range of investor required returns of 7% to 9% may seem low.  But, this is attractive compared to the recent 10-year U.S. government bond yield of under 3%.

LOWER BEGINNING EARNINGS SCENARIO

Given the uncertainty as to whether or not $70 is a representative level of the current earnings level on the S&P 500 index the table above is repeated with a more pessimistic estimate of the current normalized earnings level of $55 which is based on the latest years' operating earnings.

 

S&P 500 Current Annual Earnings Estimate	S&P 500 Current  Annual Dividends	Earnings and Dividend Growth forecast	S&P 500 P/E forecast in 10 years	Resulting S&P 500 in 10 years	Required Return	Resulting S&P 500 Fair Value Today
55	25	4.0%	13	1,058	7%	753
55	25	4.0%	15	1,221	7%	835
55	25	4.0%	17	1,384	7%	918
55	25	4.0%	13	1,058	9%	642
55	25	4.0%	15	1,221	9%	711
55	25	4.0%	17	1,384	9%	779
55	25	4.5%	13	1,110	7%	784
55	25	4.5%	15	1,281	7%	871
55	25	4.5%	17	1,452	7%	958
55	25	4.5%	13	1,110	9%	669
55	25	4.5%	15	1,281	9%	741
55	25	4.5%	17	1,452	9%	813
55	25	5.0%	13	1,165	7%	818
55	25	5.0%	15	1,344	7%	909
55	25	5.0%	17	1,523	7%	1,000
55	25	5.0%	13	1,165	9%	697
55	25	5.0%	15	1,344	9%	772
55	25	5.0%	17	1,523	9%	848

 

Lower Earnings Scenario Conclusions

Starting with an estimated current normalized earnings level of $55 and the actual dividend of $25, By changing the expected earnings growth rate, the return required by the investor and the assumed P/E ratio that will apply in ten years I can calculate that today's S&P 500 index should be anywhere from 642 (assumes that our  starting normalized earnings level of $55 is appropriate, that the market P/E falls to 13, earnings grow at 4% annually and equity investors require an expectation of making 9%) to an even 1,000 (assumes our starting earnings level of $55 is appropriate, a terminal market P/E of 17, earnings grow at 5% and investors only require an expectation of earning 7% on equities).

My own fair-value estimate at this starting earnings level is 806 based on the average of the two high-lighted rows  This assumes that investors require only a minimum 8% expected return, that the S&P earnings and dividend will grow at 4.5%  (3% GDP growth plus 1.5% inflation) and that the long run S&P 500 P/E ratio is 15. Higher S&P 500  index values are implicitly assuming that the representative starting earnings level is higher than $55, that earnings growth will exceed 4.5% annually, that the justifiable long-run P/E exceeds 15, and/or that investors require less than a 8% (pre-tax) return.

Overall Conclusion

The overall conclusion is that a fair value of the S&P 500 index based on estimated normalized annual earnings is  within the range of 741 to 1051, with a mid-point estimate of 896. Since this is based on many estimated numbers it should be taken as a rough indication and certainly not as an exact determination.  Buying the S&P 500 index when it is available at about 900 should be expected (but certainly not guaranteed) to result in an average return of about 8% per year if held for the next 10 years.  The expected standard deviation around this expected 8% is also large so that the actual return over the next 10 years might be expected to fall within a range of say 6% to 10% per year with some chance of being outside that range. And in any given year, the return will range wildly and should be expected to be negative in some years. If the S&P 500 index is currently available under 896 then you should expect a long-term average return of somewhat greater than an average 8% per year if it is held for 10 years.  If the S&P 500 index is currently over 896 then you should expect a long-term average return of somewhat less than an average 8% per year if it is held for 10 years.

I note that the reported S&P 500 P/E ratio was well above 20 for most of the last 8 years. Either the earnings were distorted (downward) or the index was overvalued. Hind-sight suggests that the index was over-valued for much of the past dozen years.

It is impossible to predict where the S&P 500 index will go in the next year. But it is possible to estimate its fair value and therefore whether or not it is currently over-valued based on reasonable growth expectations and a reasonable expectation around the initial earnings (or equivalently the  initial P/E level) and around the terminal P/E ratio. Caution is warranted because the S&P 500 can sometimes spend years in an over-valued or an under-valued-state. But ultimately, as we have seen in the early 2000's crash, and the crash of 2008, valuation does correct itself.  (and sometimes over-corrects to the downside)

Readers should see also a similar article on the Dow Jones Industrial Average.

Shawn C. Allen, CFA, CMA, MBA, P.Eng.

President, InvestorsFriend Inc. 

Updated February 20, 2009 

I first applied this analysis to the S&P 500 index on September 8, 2004. At that time (4.0 years ago) I concluded the index was probably somewhat over-valued at 1104 and priced to return no more than 7% per year on average (actually since the analysis indicated the S&P 500 index was over-valued, the analysis at that time indicated the S&P 500 was priced to return less than the required 7% per year) was .  With a current index level of 770 the return has certainly been lower than expected.

In recent months I have updated this article a number of times. At present it seems more difficult to calculate a fair value estimate of the S&P 500 index because earnings have been in a free-fall and it becomes very difficult to select a representative level for the current earnings on the index. With all the variables at play here it is possible to "torture the results"  until they confess to some pre-conceived notion of a fair value of the index. I have tried hard here not to torture the numbers. I have presented a table of results so that readers can select their own fair value estimate for various assumptions around growth, required return and the terminal P/E level. Also one could scale the fair value results up if you prefer to use a  higher estimate for "current" earnings on the index. 

www.investorsfriend.com