There's a lot of debate going on right now about whether the stock market or a proxy, the S&P 500 and its corresponding ETFs, SPY, IVV, are over-valued or under-valued. Most articles and writers quote the flow of funds, market sentiment, and Fed intervention as their thesis of how the market will perform. While these factors drive short-term stock price movement, for the long-term investor, the ultimate drivers of market valuation are two things: 1) expected earnings and 2) the discount rate.
Many articles typically quote that the market is trading at a 15x P/E, which is in-line with historical valuations, and is hence fairly or slightly undervalued. The problem is that these articles never go into detail on how they've arrived at the 15x multiple.
In actuality, that 15x P/E may not be what it seems, and the market may really be trading at close to a 19x P/E, which is a 27% higher valuation than implied by the 15x.
Let's take a look at the real numbers. I gathered this data from the S&P Indices website.
On a trailing twelve-months ("TTM") basis, the S&P is now trading at almost 18.9x earnings of $87.7. This is probably at the high end of a normal trading range.
Looking at the next twelve-months, the S&P is trading at 14.6x consensus earnings estimates of $113.4. Could this be the magic 15x P/E that's often quoted? Maybe. Probably likely. But what does it mean?
To go from $87.7 in earnings to $113.4 means a 29.3% growth over the course of a year.
Where Will Earnings Growth Come From?
There are only two ways to grow earnings: 1) higher sales or 2) higher margins, or a combination thereof.
Higher Sales: Currently, TTM sales are at $1,091, growing only 2.5% year over year. Future top-line growth is likely to be even slower as a result of weak economic factors. In fact, the fastest rate that sales have grown was only 12.6% in late 2005, in the midst of a housing bubble. This growth is nowhere near the 29.3% needed to get to the $113.4 in earnings.
Higher Margins: Current net margins are at 8.0%, near the historic high of 8.6% achieved in late 2007. Even if margins are to expand to historic highs, this is only a 7.5% increase in earnings, not nearly enough to get to the predicted 29.3% higher earnings.
If you want to get extremely aggressive and say that earnings will grow at historic high rates of 12.6% and margins will expand to historic highs of 8.6%, that will get you to earnings of $111.1 for next year. Still short of the current $113.4 consensus.
So, it's pretty obvious that the $113.4 earnings estimate is way too high, and the market, at least on the earnings side, appears more over-valued than on the surface. Earnings will continue to be revised downward as it has been for the past year.
I don't like to make predictions, but for the sake of making things interesting, if we use a 1.5% sales growth on current sales of $1,096, and a margin of 8.0%, you get an earnings of around $89. This implies a forward P/E of 18.6x. Now the market does not look as undervalued as most bullish article writers seem to make it sound.
The numbers don't lie, only humans choose to lie to ourselves.