Fair Value for the S&P: It's Not 440

Barry Ritholtz, market veteran and blogger over at The Big Picture, postulated today that fair value for the S&P 500 might be 440. He got there by taking trailing 12 month GAAP earnings of $28.75 and applying a 15 P/E ratio to them.

Personally, I expect more from Barry, given how strong much of his market and economic analysis has been over the years, but there are glaring flaws in this valuation methodology. First, I don’t know very many market strategists who believe fair value on the S&P 500 should be based on the earnings produced by the index’s components in the depths of a deep recession. Most people agree that fair value should be based on an estimate of normalized earnings, not trough (or near-trough) profit levels.

Imagine you owned a Burlington Coat Factory retail store. You are ready to retire and have a businessperson interested in buying your store. What would your reaction be if this person took your store’s profit for the month of June, multiplied it by 12, and based his offer price on that level of projected annual profits? Clearly that figure does not give an accurate representation of how much money your store earns in a year because June is probably one of your worst months of the year for selling coats!

The same flaw exists in valuing the stock market based on current earnings. Doing so implies that earnings today represent a typical economic climate, which is clearly not the case.

The second issue with Barry’s analysis is the use of “as-reported” GAAP earnings. The reason GAAP earnings have fallen so fast is that they include non-cash charges such as asset impairments. It is common these days for companies to report cash earnings of $1 billion but a GAAP loss of $5 billion due to a $6 billion asset impairment charge. In such a case GAAP earnings (which include the non-cash charge) are understated by a whopping $6 billion. Why should asset impairments be excluded? A stock’s value is based on the present value of future free cash flow. Since cash flow is what matters to investors when valuing the market and specific stocks, non-cash accounting adjustments (such as asset impairments) don’t really play a role in fair value estimations.

The interesting thing is that you don’t have to take my word for it on this topic if you don’t want to. The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings (S&P 500 at 834 divided by 28.75) is excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.

Comments

[Jeffrey A. ...:]

I'm not the brightest bulb in the chandelier so please explain what exactly, constitutes "normalized earnings"? (And why should I care?)Such a phrase suggests excluding events that are supposedly one off events. As is usual in such an circumstance that may make some sense such as a one time write down of the value of an investment. One concern is how often can we exclude such one time events that seem, curiously, to occur fairly often?

In the past I have used the reported operating earnings number to calculate a "fair value" for the S&P 500 using 10 year Tbill rates. That and $4 will get me a Starbucks latte. It is an interesting exercise but after a bit the thrill was gone. The market doesn't give two hoots about some academic assertion of "fair value". It does care about future earnings if investors have a long enough time horizon. Those with short time horizons are basically momemtum traders.

I have read that 2009 S&P 500 operating earnings (which excludes those 'one time events') may be in the $60 range. If I assign a 15 PE to that then fair value may be 900. If I assign a 10 PE then fair value is 600. It is not clear to me why a higher PE is reasonable for a seriously reduced earnings stream especially in an environment of extremely low interest rates. Yes, I understand the inverse might be more normal (low rates = higher PE) but those low rates are indicative of probable weak earnings not an harbinger of future gains.

Bottom line: while GAAP earnings include supposed one time events as if they were routine the 15 PE is overstating the future value of whatever the earnings will be.

Feb 13 04:08 PM

[infp:]

I still own underwater stock from the dotcom-bomb of 2000. I can't wait until these values return to "normal" so I won't be out so much money.

Feb 13 05:17 PM

[Stone Fox C...:]

So why would you use trough earnings to value stocks? Surely you'd agree that the earnings made during a recession are depressed beyond normal levels. Thats why the theory of normalized earnings comes about. What would earnings be if the economy grew at a 'normal' 2-3% rate each year. The stats I've seen show $100. Maybe thats too aggresive and we'll actually see a downshift in what is considered normal going foward, but I'd then have to argue that $80-90 would be much more normal then the current $60. This years expectations have to clearly be the trough going forward.

Feb 13 05:17 PM

[donzelion:]

I like the coat factory example, but find it misleading for several types of equities. Sure, your store has had good and bad years, so a valuation mechanism based on an earnings trough would seem abusive. Then again, markets are routinely abusive, and if you are in a must-sell position, it won't matter that the only buyer in town offers less than you wish.

As for the drop in earnings - certainly, cash impairments suck, but the other side is that the markdowns suggest that profits in recent years were likewise escalated. If you take out the "mark ups" from 2003 - 2008, you balance with the "mark downs" during the trough - and find there's been very, very little earnings for the last 10 years. The dot-com bust never really ended, except for financial shenanigans.

Feb 13 05:27 PM

[Prudent Man...:]

This begs the question: Is this the trough in earnings?

Feb 13 05:44 PM

[mac.barron:]

Two more cents on the Coat Factory example. Granted it was a very smart way to make your point clearly, the comment stream shows that you really connected with the readers. The difficulty is that if one is trying to sell a business its true value is only what the highest bidder will pay. If the guy who wants to use the summer sales figure is your highest bidder and you must sell, guess what? He's right. If you can afford to wait around then he will likely be wrong, but the value of a thing, whatever that thing is, will be to a large degree a function of how badly the seller needs the cash.

The companies that make up the S&P 500 are obviously worth more than 15x 12-mo. trailing GAAP earnings if you can wait around and get the best price for each one, but in terms of what Mr. Market may be willing to pay in U.S. Dollars over the nest few quarters I'm going to guess that the truth may be closer to 440 then to 827 as of close today.

Feb 13 05:57 PM

[TA:]

Ritholtz is only one of many Dr Doom's leading the herd around. If the S&P was 400, he'd being saying it should be 200.

I can't really complain though, all these doomsayers are helping to create the juiciest put premiums in a decade so if the author or Stone Fox Capital can refrain from posting any common sense, it would be appreciated.

Feb 13 06:51 PM

[endoftheworld:]

If some company pays $1billion for a company that's later not generating any value, its goodwill should be written down. Technically its a non-cash writedown, but all NON-CASH charges have their origin in CASH. Its just that the initial cash outlay is "amortized" over a longer period of time from an accounting perspective. Either you should value companies on the basis of cash flow alone, or GAAP earnings. Trying to mix the best of both worlds will lead to a ridiculously inflated answer. This is basically what happened with stock option expensing. If someone walks away with $10m in stock, is that non-cash? where did that "non-cash" come from? if you get paid in gold, that'll be non-cash too - should we exclude that as well?

Goodwill/Intangible impairments only exist because the cash left a long time ago, and only now are the investments being realized as duds. If the company were to develop their own products internally, that'd be a real cash outlay - only now the company is prepaying a lumpsum for a ready-made solution (the acquisition). You should then either report a billion dollar loss and use that in your "normalized" earnings or use GAAP all the way consistently.

Feb 13 07:16 PM

[Megeyer1:]

Blah, Blah, Blah. Instead of guessing or trying to make a point with the coat factory stuff. Take a trip down memory lane and look at the earning levels in past recessions. Try 10. That is reality

Feb 14 07:57 AM

[Nick Gogerty:]

If anyone is interested in a chart of the historical earnings going back to 1988 and the forward S&P estimates:have a look here nickgogerty.typepad.co... The last 3 years look more like the overpriced anomaly. I have also posted the shiller data going back to 1871 in excel for those who need more data.

Feb 14 09:07 AM

[Annualgain:]

It's true that STOCKS can trade at a higher multiple of trough earnings, like a commodity company whose earnings go to $0.01 can trade at a multiple of something like 10,000. But the STOCK MARKET usually does not behave that way. It seems likely that the market will bottom at 10-12x ongoing, operating earnings.

Feb 14 09:42 AM

[prudentinve...:]

In past recessions, pre-bubbles era, stocks were priced at roughly 10 times the earnings at the trough. The author is saying that it is "unfair" to value an asset based on its trough earnings, but that is how the market has worked in the past.

At present, many of the younger money managers have the author's mindset, and are willing to pay for stocks (mostly with other people's money), at valuations that greatly exceed Mr. Ritholtz's notion of fair value around S&P 440. This is why the process of discovering the depths it may plumb may take more time.

All anyone can do at present is guess, as there are many participants who see things like Mr. Ritholtz, and many others who see them like the author. My own guess, for what its worth, is that we still have some considerable downside ahead of us, but doubt that it will take us all the way down to 440. Naturally, this is an evolving guess.

Feb 14 09:43 AM

[dcb:]

In my view the best approach is to look at the marco factors, use some technical analysis, and realize this is going to be one long recession to take your time and find good price points. additionalsome day trading to make some money while the buy and holds drop. Most of the charts I look at appear to be descending triangles, which if they dop below imply at further 20% drop. Unfortuantely this isn't going to happen fast so we can all jump in. oil, mining, preferred shares appear to be moving upwards and splitting from the descending triangle. I'm stayings as far away as ai can from the american consumer, and will be buying ews, and singapore, (the most beaten down) with some stocks in countries with good natural resources as well. No matter what populations continue to grow and they have to be fed, buy fuel, etc. I'm staying as far away from the american consumer as I can. history says we should be saving about 10%, we had zero savings so there is a long way to go. since consumer spending makes up 70% gdp we are in trouble. don't forget the wealth lost the past year will curb spending for years in order to make up for the loss. Additionally, it will be a long time before retail investors trust wall street again unless there is some real reform and some better alignment of manger's interests with the real economy. I don't count on this happening because there is too much cash flow between washington and wall street. washington will make it look to the public like they are doing something, but behind the scenes is a different story. If the market turns up quickly, I'd expect another crash because it measn we have just made a system that has all the old instabilities. (too much leverage, too much debt, too much off balance sheet liabilities, accounting gimmicks (getting rid of mark to market)). Fixing the mess will be a long and difficult process which is something the public has no stomch for, won't get votes in washington, and industry will fight tooth and nail. For god's sake the industry is fighting a cds clearning house, leverage limits, and transparency. Does that inspire you to put your money there again?

Feb 14 10:02 AM

[John Groom:]

Why do this year's expectations have to be the trough? Why couldn't earnings keep going down, as is the economy?


On Feb 13 05:17 PM Stone Fox Capital wrote:

> So why would you use trough earnings to value stocks? Surely you'd
> agree that the earnings made during a recession are depressed beyond
> normal levels. Thats why the theory of normalized earnings comes
> about. What would earnings be if the economy grew at a 'normal' 2-3%
> rate each year. The stats I've seen show $100. Maybe thats too aggresive
> and we'll actually see a downshift in what is considered normal going
> foward, but I'd then have to argue that $80-90 would be much more
> normal then the current $60. This years expectations have to clearly
> be the trough going forward.

Feb 14 12:58 PM

[BobFD:]

I am guessing that you are either joking or confused like most other so-called "investors". While I agree with your statement:

"Barry Ritholtz, market veteran and blogger over at The Big Picture, postulated today that fair value for the S&P 500 might be 440. "

my reason for agreement is quite different than yours. The fact is Barry is off, because the fair value of the S&P is likely closer to 100 than 440. Why? Because I value stocks the way they should be valued----real earnings. Real earnings means you do factor in charges. I always love it when people like yourself try to "justify" a stocks price by taking out all the one time charges. Look, every quarter there will be one time charges,l and they should be accounted for.

Saying that one time charges should not be accounted for is what got us into this mess. Yep, it is people like you that say----well, I only made $50,000 last year but spent $100,000, but that car, vacation, and new refrigerator were "one-time" charges----if I had not bought those I would have only spent $50,000. Companies have figured out that they can report their earnings this way, and the "dreamers, wishers, and hopers" that just want the market to "go up" will accept the numbers without question.

Look, if you give me $1,000,000 a year, I can run a business that can show a profit. Yep, what I will do is take the $1,000,000, buy product and sell it for $800,000. Then, at the end of the year, I will report that I made $800,000 and that I had $1,000,000 in "one-time" expenses.

The bottom line is that saying the S&P is worth 100 is probably a stretch---the fact is most companies do not make money---they exist for nothing more than to enrich the exective insiders and employees. Why is that so hard for people to understand? Is it because you "want to believe", because "hope", because you want the stock to "go up"?

I will never understand how people fall for the ponzi scheme we call the stock market. I will acknowledge that if the S&P dropped to fair value (around 1, maybe 2), perhaps people would finally start reporting real earnings and we could start honest accounting again. However, this "one-time" charge garbage is getting old, and valuing stocks by subtracting one time charges is insane. Like I said, give me $1,000,000 every quarter, I will give you $800,000 in sales and $1,000,000 in "one-time" charges---I have to buy the product to sell---who cares if I sell for less than I paid for it---that is a "one-time" charge.

Feb 14 05:37 PM

[Fliujniligui:]

Maybe valuing market with earning during the worst period can not be fairly accurate. However, such estimate may help predict how low it may go. In panic time and short term fear, earnings of yesterday are relevant, earning in 5 years and average earnings are far too complex for an adrenalinized brain to take in account.

Feb 14 08:11 PM

[Goodyman:]

The profit margin for the S&P had been at all time highs from 2004 - 2007. Those are not normal earnings, my friend. Normal earnings would need to be normalized for narmal margins, at a minimum. Add to that the amount of leverage in the economy which was further driving top lines and the normal earnings picture takes another step further backwards.

What tomorrow holds is anyone's guess. My guess is that times will be much more austere. The S&P at 600 or less is well within the realm of reason to way way of thinking based upon a different view of what earnings are likely to be in a normal sense.

Feb 14 09:22 PM

[Maxe Paul:]

The market is quite clearly being manipulated by the "plunge protection team" at the s&p 800 level. If you want to believe this is the bottom, then i wont stop you. If you think normal has any basis, again good luck.

The market will eventualy be fair priced to reflect the constant rising unemployment and consumer strike. I expect we will see the "real value of the S&P when a major country (or countries!) defaults on it's debt. Im tipping this will be sooner than we think.

Feb 15 06:35 AM

[Fred Voetsch:]

Another fool who can't step outside of his limited lifespan.

First of all go back and look at P/E ratios in secular bear markets; you'll see that P/E's after the Great Depression stayed very low for decades and that in the 70's they were very low. 15 IS A HIGH P/E RATIO IN A SECULAR BEAR MARKET. Sorry to scream but these fools don't seem to be pay attention to FACTS.

What Chad doesn't get is that the stock market and real estate market and everything else has been leveraged up over the past two decades and now it will be leveraged down for a similar amount of time, during which P/E ratios will be abnormally low.

What Chad also has failed to notice is that earnings are ACCELERATING DOWNWARD. They dropped over 40% year-over-year last quarter and have shown no signs of improving.

Feb 15 04:37 PM

[Fred Voetsch:]

On Feb 14 05:37 PM BobFD wrote:

> my reason for agreement is quite different than yours. The fact is
> Barry is off, because the fair value of the S&P is likely closer
> to 100 than 440. Why? Because I value stocks the way they should
> be valued----real earnings. Real earnings means you do factor in
> charges. I always love it when people like yourself try to "justify"
> a stocks price by taking out all the one time charges. Look, every
> quarter there will be one time charges,l and they should be accounted
> for.


Exactly! If you look at long term charts they use "as reported" earnings which include one-time charges because as any busines owner knows, one-time charges happen all the time, you just can't count on them the way you could your normal payroll, for example.

Long term charts suggest this market will easily drop below 500 and is likely to go as low as 3,000 and given the incompetence of our government, 150 isn't out of the question.

Here is a great article on valuing the market with some excellent info and links: www.generationaldynami...

Feb 15 04:43 PM