DOES THE S&P 500 P/E RATIO AND INDEX VALUE REPRESENT A GOOD INVESTMENT AT THIS TIME? (October 5, 2008 at 1099)

UPDATE - As of October 11, the S&P 500 index has fallen 18% in the past week to 899. Based on the analysis below this index now appears to be about 9% under-valued. This assumes that the S&P 500 earnings can be expected to grow at 5% per year on average and sell at a P/E of 15 in ten years. Even assuming 4% growth and a P/E of only 13 in ten years, the fair value of the S&P 500 is 822, which would indicate it is 9% over-valued. Due to recent unusual write-off by some of the larges S&P 500 companies, the current earnings on the index are low and this is causing our valuation to be conservative. For this reason the S&P 500 is probably more under-valued than our analysis indicates.

The overall conclusion is that at its current level of about 1099, the S&P 500 index is perhaps 10% over-valued and will result in a return expected to be in the 6% range in the long-term. Since this is based on many estimated numbers it should be taken as a rough indication and certainly not as an exact determination.

This article uses the P/E ratio and expected growth to analyze whether the S&P 500 index seemed over-valued or under-valued at this time. We also provide a link to Standard and Poors where you can find updated information on the P/E ratio and earnings estimates for the S&P 500 index.

An analysis of the fair value of the S&P 500 index will not provide a short-term indicator of market direction but it should provide a long-term indicator of the expected return from investing in the S&P 500 index at this time.

What is the P/E ratio on the S&P 500 index right now? (with the index at 1099)

Data from Standards and Poor itself provides no less than five quite different answers.

21.3 based on actual trailing reported earnings for the last year (latest four quarters)
15.8 based on trailing operating earnings for the last year (removes "unusual" items)
18.2 based on forecast reported earnings for the next year (next four quarters)
11.1 based on forecast operating earnings for the next year (estimates summed by individual company)
16.0 based on forecast operating earnings for the next year (estimates for the group of companies)

The above numbers are from Standard and Poors at: http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS (Their figures were for an index level; of 1166 as at September 30, so we adjusted the figures to reflect the most recent index value of 1099).

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

The most attractive version of the P/E is the 11.1 resulting from the summation of analyst estimates of operating earnings for the next 12 months for all the 500 individual companies. This can be dismissed as far too optimistic.

Below we delve into this issue in more detail.

The attractiveness of the S&P 500 index level can be judged by looking at the current level of earnings and dividends of the S&P 500 index stocks, projecting the future rate of earnings and dividend growth and by considering the minimum return required by investors. Analysts often apply valuation techniques to individual stocks. It is actually far easier to apply these calculations to a stock index since an index constitutes a portfolio and therefore eliminates most of the random noise of unexpected events through diversification. Still, many challenges remain in applying this analysis and its results while providing some indication for the long-term and offer no insight for the short-term. The index remains vulnerable to changes in interest rates and to growth in the economy but is usually largely insulated from the numerous random events that can impact an individual stock.

As of  October 5, 2008, the S&P 500 index was at 1099 and had a Price Earnings Ratio ("P/E") of 21.3 based on actual trailing reported earnings and a current Dividend yield of 2.55%.  The trailing P/E based on operating earnings (eliminates unusual one-time items) was 15.8.  The forward S&P 500 P/E ratio based on projected reported GAAP earnings in the next 12 months was 18.2. The forward P/E based on forecast operating earnings in the next 12 months (eliminates unusual one-time items) is much more attractive at 16.0 (based on an overall index forecast) and impossibly optimistic at 11.1 based on the summation of individual operating earnings for the 500 companies.

Given that projected earnings tend to be optimistic, I normally prefer to use the actual trailing P/E. At this point in time both the trailing and forward P/Es based on actual and forecast reported earnings have been driven higher due to an extremely large unusual loss at General Motors and another at Sprint Nextel and numerous large losses at financial institutions. Normally I would use the actual trailing P/E. In this case the the unusual losses were very large and so I will use the average of the trailing actual P/E and the trailing operating P/E. This creates an adjusted trailing P/E of 18.5. (At this time the P/E ratio is less meaningful than normal due to the large difference between the actual earnings and the operating earnings.)

The S&P 500 index represents a portfolio of 500 stocks. For each $1099 (the index value)   purchased, the underlying companies in the portfolio have earned $1099/18.5 = $59 (this is based on our adjusted trailing P/E ratio of 18.5)  in the last 12 months (to March 31, 2008) and currently pays an annualized dividend of $1099 * 0.0255 = $28. 

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. In fact this $59 we have used is 11% below the earnings from 2007 and 28% below the 2006 earnings and therefore it does not seem unrealistically high at all and in fact may well be too conservative.

When we Buy the S&P 500 index, we can therefore think of it as being an investment or "stock" that (as of October 5, 2008) costs $1099 and currently earns $59 per year and pays a current dividend of $28 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of $1099.

We know that the S&P 500 index was at 1099 on October 5, 2008. We can estimate what the S&P theoretically "should" have been 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 articles that both explain why (quoting Warren Buffett) and also demonstrate that earnings tend to grow at about the same rate as nominal GDP growth in the long run.

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 12.5 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.

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	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
59	28	4%	13	1,143	7%	822
59	28	4%	15	1,319	7%	911
59	28	4%	17	1,495	7%	1,000
59	28	4%	13	1,143	9%	701
59	28	4%	15	1,319	9%	776
59	28	4%	17	1,495	9%	850
59	28	5%	13	1,258	7%	892
59	28	5%	15	1,451	7%	991
59	28	5%	17	1,645	7%	1,089
59	28	5%	13	1,258	9%	761
59	28	5%	15	1,451	9%	843
59	28	5%	17	1,645	9%	924
59	28	6%	13	1,383	7%	969
59	28	6%	15	1,596	7%	1,077
59	28	6%	17	1,809	7%	1,186
59	28	6%	13	1,383	9%	825
59	28	6%	15	1,596	9%	915
59	28	6%	17	1,809	9%	1,005

 

 

Conclusions

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 701 (assumes market P/E falls to 13, earnings grow at only 4% annually and equity investors require an expectation of making 9%) to 1,186 (assumes terminal market P/E of 17, earnings grow at 6% and investors only require an expectation of earning 7% on equities).

My own fair-value estimate is high-lighted in yellow and is 991. This assumes that investors require only a minimum 7% expected return, that the S&P earnings and dividend will grow at 5%  (3% GDP growth plus 2% inflation) and that the long run S&P 500 P/E ratio is 15. Higher S&P 500  index values are implicitly assuming that earnings growth will exceed 5% annually, that the justifiable long-run P/E exceeds 15, and/or that investors require less than a 7% (pre-tax) return.

Since the S&P 500 index is currently  about 1099, I conclude that it appears to be about 10% over-valued. If the S&P 500 index were fairly valued it would return the required 7% per year. At 10% over-valued we might expect instead to earn an average of 6% per year if held for about 10 years.

The table illustrates quite a wide range for a reasonable fair value of the S&P 500.  Investors should be sobered by the fact that if investors require a 9% rate of return and if the earnings only grow at 5% (say 3% GDP plus 2% inflation) and if the S&P commands a P/E of only 13 in ten years then the fair value of the S&P today is calculated as only 761, which is 31% below the current value!

Most investors would probably not admit to being happy with a 7% return, but the level of the S&P suggests that investors have bid stocks up to the point where probably no more than about 6% is a realistic long-term return. But, this is attractive compared to the recent 10-year U.S. government bond yield of about 3.6%.

The overall conclusion is that at its current level of about 1099, the S&P 500 index is perhaps 10% over-valued and will result in a return expected to be in the 6% range in the long-term. 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 today should be expected (but certainly not guaranteed) to result in an average return of about 6% per year if held for the next 10 years.  The expected standard deviation around this expected 7% is also large so that the actual return over the next 10 years might be expected to fall within a range of say 4% to 8% 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..

Here is another way to look at the calculation. If we expect the trailing S&P 500 P/E ratio to trend back from 18.5 to 15.0 over ten years (a 19% reduction, or 1.75% per year) then the amount we we should expect to earn by investing in the S&P 500 index is equal to our earnings growth assumption plus the dividend yield less a reduction of about 1.75% per year for the P/E regression. Thus with a 5% earnings growth assumption, plus 2.5% for dividends less the 1.7% for P/E regression we could expect to earn about 5.8% per year. (This is very close to our 6.0% calculated above)

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 period from 1997 to 2003.

It is impossible to predict where the S&P 500 index will go in the next year. But it is relatively easy to calculate whether or not it is currently over-valued based on reasonable growth expectations and a reasonable expectation around the 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, valuation does correct itself.

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 October 5, 2008 

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 1099 it has returned an annualized  average (but very lumpy) capital gain of almost precisely 0.0% per year plus a dividend of about 2.2% for a total return of 2.2% which was lower than expected. Earnings growth until recently was significantly higher than the expected 5%. However with the recent earnings declines the earnings growth has now averaged (coincidently) only about 0.0% per year.  The lower-than-expected return is explained by the fact that the earnings failed to grow.  Earnings growth for a broad stock index tends to match the growth in nominal GDP over the long-run.

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