DOES THE S&P 500 P/E RATIO AND INDEX VALUE REPRESENT A GOOD INVESTMENT AT THIS TIME? (June 1, 2008)

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Should you believe those who claim that stocks are cheap because (they claim) the P/E ratio on the S&P 500 index is low at 12.9? But wait a minute, they are not talking about the actual P/E of 23.2 based on actual achieved earnings in the last 12 months. Many analysts will point out that the actual trailing P/E of 23.2 is distorted upwards by “unusual” and “one-time” write offs at the likes of General Motors and at many big financial institutions. These optimistic analysts prefer to focus on “operating earnings” which ignores one-time items. (But the funny thing is over 500 stocks we will always have some one-time items, and they always seem to be negative in the aggregate, and can we really ignore these?). Optimistic analysts will also point out that stock valuation depends on future earnings and direct us to the forecast operating earnings in 2009.

The forecast operating earnings for 2009 on a “bottom up” basis adding up the forecast for the 500 companies results in an attractive looking P/E of 12.9. But on a “top-down” basis the forecast operating earnings for 2009 result in a much less attractive P/E of 18.4. Meanwhile the forecast for actual reported GAAP earnings in 2009 results in a P/E of 20.4, which is not attractive.

I believe it is very dangerous to focus on the the optimistic operating earnings figure for 2009 resulting in the attractive looking P/E of 12.9. I believe it is irresponsible and misleading to state that the S&P 500 P/E is 12.9 without pointing out that this is based on forecast 2009 operating earnings and is not based on actual achieved historical GAAP earnings. Based on the forecast GAAP P/E of 20.4 times forecast 2009 earnings, the S&P 500 index is clearly expensive and does not appear to represent good value at this time.

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. 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  June 1, 2008, the S&P 500 index was at 1400 and had a Price Earnings Ratio (“P/E”) of 23.2 based on actual trailing reported earnings and a current Dividend yield of 2.07%. The trailing P/E based on operating earnings (eliminates unusual one-time items) was 18.2.  The forward S&P 500 P/E ratio based on projected reported GAAP earnings in the next 12 months was 19.9. Source: http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS. The forward P/E based on forecast operating earnings in the next 12 months (eliminates unusual one-time items) is much more attractive at 14.4.

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 20.7. (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 $1400 (the index value) purchased, the underlying companies in the portfolio have earned $1400/20.7 = $68 (this is based on our adjusted trailing P/E ratio of 20.7)  in the last 12 months (to March 31, 2008) and currently pays an annualized dividend of $1400 * 0.0207 = $29.

When we Buy the S&P 500 index, we can therefore think of it as being an investment or “stock” that (as of June 1, 2008) costs $1400 and currently earns $68 per year and pays a current dividend of $29 per year. It is worth thinking about whether or not this “stock” is a good investment at or around its recent level of $1400.

We know that the S&P 500 index was at 1400 on June 1, 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.

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
68	29	4%	14	1,402	7%	961
68	29	4%	16	1,602	7%	1,063
68	29	4%	18	1,802	7%	1,165
68	29	4%	14	1,402	9%	818
68	29	4%	16	1,602	9%	903
68	29	4%	18	1,802	9%	987
68	29	5%	14	1,542	7%	1,046
68	29	5%	16	1,763	7%	1,158
68	29	5%	18	1,983	7%	1,270
68	29	5%	14	1,542	9%	889
68	29	5%	16	1,763	9%	982
68	29	5%	18	1,983	9%	1,075
68	29	6%	14	1,696	7%	1,137
68	29	6%	16	1,938	7%	1,260
68	29	6%	18	2,180	7%	1,384
68	29	6%	14	1,696	9%	966
68	29	6%	16	1,938	9%	1,068
68	29	6%	18	2,180	9%	1,170

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 818 (assumes market P/E falls to 14, earnings grow at only 4% annually and equity investors require an expectation of making 9%) to 1,384 (assumes terminal market P/E of18, earnings grow at 6% and investors only require an expectation of earning 7% on equities).

My own fair-value estimate is highlighted in yellow and is 1158. 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 16. Higher S&P 500 index values are implicitly assuming that earnings growth will exceed 5% annually, that the justifiable long-run P/E exceeds 16, and/or that investors require less than a 7% (pre-tax) return.

Since the S&P 500 index is currently  about 1400, I conclude that it appears to be about 20% over-valued.

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 14 in ten years then the fair value of the S&P today is calculated as only 818, which is a sickening 42% below the current value!

(Note the high light on the above paragraph was added August 2009, just to point out that this article in the past did indicate that the S&P could be considered high)

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 7% is a realistic long-term return. This is attractive compared to the recent 10-year U.S. government bond yield of about 4.1%.

My overall conclusion is that at its current level of about 1400, the S&P 500 index is perhaps 20% overvalued and will result in a return expected to be in the 5% range in the long-term. Buying the S&P 500 index today should be expected (but certainly not guaranteed) to result in an average return of about 5% per year if held for the next 10 years.  The expected standard deviation around this expected 5% is also large so that the actual return over the next 10 years might be expected to fall within a range of say 3% to 7% per year with some chance of being outside that range. And in any given year, the return could certainly be negative.

If we expect the trailing S&P 500 P/E ratio to trend back from 20.7 to 16.0 over ten years (a 23% reduction, or 2.3% 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 2.3% per year for the P/E regression. Thus with a 5% earnings growth assumption, plus 2.1% for dividends less the 2.3% for P/E regression we could expect to earn about 4.8% per year.

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. Hindsight suggests that the index was overvalued 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 overvalued 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 June 1, 2008

I first applied this analysis to the S&P 500 index on September 8, 2004. At that time (3.5 years ago) I concluded the index was probably somewhat overvalued 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 1400 it has returned an annualized average (but very lumpy) capital gain of 7.0% per year plus a dividend of about 1.8% for a total return of 8.8% which is somewhat higher 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 only 4.1% per year.  The better-than-expected return is explained by the fact that the P/E ratio (now at 20.7) did not decline to 16 as expected. (Actually the P/E ratio did decline to about 16 but has now risen as earnings evaporate). Earnings growth tends to match the growth in nominal GDP over the long-run.