S&P 500 Valuation and Earnings Analysis

In this article I will be discussing the S&P 500 index with respect to the historical and current valuation of the index and the historical and current earnings of S&P 500 Companies and also the earnings estimates for 2010 for the S&P 500 index.

The objective is to give investors an idea of where the index is currently in terms of valuation and also analyze if the 2010 earnings estimate for the S&P 500 index is realistic.

Since this article will be looking into the P/E based valuation for the S&P, I would like to point out certain facts about S&P earnings which are used to derive the P/E for the index.

The P/E that is generally calculated is done from the operating earnings of the S&P 500 companies.

The Operating earnings as defined by S&P is:

Income from product (goods and services), excludes corporate (M&A, financing, layoffs ), and unusual items.

So this generally excludes all unusual items or things like major write offs and other extraordinary expenses which do not recur or ideally should not recur in a normal business scenario.

However, in this article, I will be looking at P/E based valuations for the S&P based on the operating earnings as well as the reported earnings.

The Reported earnings as defined by S&P is:

Income from continuing operations, also known GAAP (Generally Accepted Accounting Principles) and As Reported

Reason for Analyzing S&P valuation using reported earnings:

The operating earnings eliminates the effect of one time items in its calculation. However, a lot of these one time expenses or major write off impacts the health of the Company. So it should also impact the valuation of the Company. But when these items are not taken into consideration, especially when most are negative, it does boost the earnings picture.

So in my opinion, it is fine to consider P/E valuation for the index based on operating earnings. But at the same time, P/E valuation based on actual earnings should also be highlighted. One can then leave it to investors to decide which number makes more sense to them.

S&P 500 PE ratio Chart (1988-2009):

In order to discuss the current valuation of the S&P in detail, I would take the help of the P/E chart for the S&P from 1988-2009. Given below are the charts for the P/E calculated from the operating earnings as well as the reported earnings for the S&P 500 stocks.

The P/E has been calculated on a quarterly basis and the earnings are of the trailing twelve months.

Chart -1
S&P 500 PE based on Operating earnings



Chart -2
S&P 500 earnings based on Reported Earnings


Key Observations based on the above Charts

• As on 30th June 2009, the S&P was trading at a P/E (As per TTM EPS) of 22.99 based on operating earnings. During the same period S&P 500 was trading at a P/E of 117.56 based on reported earnings.

• Currently (22nd August 2009) the S&P is trading at a P/E of 25.67 and 131.2 based on operating earnings and reported earnings respectively.

• Based on operating earnings, the S&P valuation has not gone above 29.5 (on a quarterly basis) since 1988. The S&P was trading at these valuations during the peak of the U.S. stock market bubble in the year 2000. Thus, the current P/E of 25.6, just one year after the world saw one of the worst financial crisis, is relatively very expensive in my opinion.

• The data looks even more interesting based on reported earnings of S&P 500 companies. The highest P/E (on a quarterly basis) based on reported earnings was 46.4 during 2001-02. Currently the S&P 500 is trading at a P/E of well over 100. Thus the S&P 500 index is terribly overvalued based on reported earnings.

One might argue that this is due to one or two time major write offs. But as I said before, even that affects the fundamentals of the Company and thus the returns to the shareholders. So it is always a good idea to take that into consideration as well in judging the valuation for the index.

Thus, in my opinion, the S&P 500 index is at overbought levels currently and a major correction should come relatively sooner. I don't predict a crash in the U.S markets or for that matter any market in the world. This is not because of great Company fundamentals or a very rapidly improving economy. It is just because of the huge liquidity that is present in the financial system that all asset markets will remain supported.

The S&P 500 Earnings Analysis

It is very interesting to look at the earnings estimates put forward by the S&P analyst for 2010. According to the estimates the operating earnings per share for the S&P 500 index for 2010 will be $73.05. Before I comment on this earnings estimate, I would like to present the historical operating earnings for the S&P 500 index.



Key Observations

• The S&P 500 index stocks earnings were at $76.4,$87.7 and $82.5 during 2005,2006 and 2007 respectively. This was the time when the whole world was at the peak of economic activity. It was one of the best times for Corporates globally. Thus, we can say that the S&P earnings peaked out at $87.7 during 2006.

• The healthy earnings of S&P during the period mentioned above was largely due to robust earnings from the financial sector, energy sector and also consumer discretionary sector.

• My concern about the S&P 500 earnings estimate arises from this fact. How can analyst predict earnings for 2010 for S&P to be 73.05 when we are just trying to get out of a major recession and when the health of financial companies is still a big concern. Coupled with this, the consumption has still shown no major signs of recovery. So how can S&P 2010 earnings be as good as (or close to) 2005-2007 earnings when none of these concerns were there.
• I would also like to mention that many analysts are talking about the recovery in the U.S economy which is evident from the fact that the economy shrunk only 1% in Q2 2009 as compared to 6.4% in Q1 2009. But what has led to this recovery? The answer is that the government sector has expanded while the private sector is still declining or just stabilizing. Clearly when we are talking about the S&P 500, we are talking about the private sector. So how can recovery for the private sector become suddenly so robust. I am very sure it will not be the case.

• So in my opinion, the S&P is discounting false earnings estimates for 2010. This makes the index even more overvalued and when the real earnings come in, the index will adjust accordingly.

• I must mention here that out of the 470 (out of 500 in the index) companies that have reported their Q2 2009 earnings so far, only 104 companies have reported sales growth and only 150 companies have reported actual earnings growth. So the picture does not look very rosy here.

Conclusion:

In my opinion there are 2 factors which will lead to correction and resistance to move to higher levels for the S&P:

• A very high valuation in the markets as of now based on both operating earnings and reported earnings and
• A very high 2010 EPS estimate which is bound to dissapoint. When it does, then markets would correct accordingly.

Disclosure: No Positions in Equities as of now

Comments

[The Geoffster:]

Please don't humor Cetin the Spammer.


On Aug 23 12:47 PM Faisal Humayun wrote:

> Yes the markets can go up in nominal terms...and if interest rates
> are kept this low coupled with more stimulus packages ur target of
> 14k or 20k is very likely...
>
> But markets will still be down in real terms...This has already happened
> since the year 2000...The U.S. markets are in a bear market since
> then in real terms...

Aug 23 01:50 PM

[E Nuff Sed:]

Right now the market is a recovery play ruled by technicals not fundamentals. With each dip is a psychological cover for scaredy cat's who missed the rally, and capitulating bears to get back in the market.
Some time in the the near future sanity and fundamental will start reasserting themselves.
However in recession - P/E ratio's are not much use - you have to look at PE10's to assess if the market is over valued or under valued.
dshort.com/charts/SP-a...

Aug 23 02:53 PM

[lblaine:]

As you said, the asset prices will continue to be supported by the huge liquidity in the system. With all governments stimulating their economies, maintaining artificially low interest rates, and virtually giving money to the banks, equities prices (in nominal terms) will continue to go up. With the US government committed to 10 trillion in deficits over the next eight years (these will at least be double that per prior government estimating prowess), the DJIA will easily reach 50,000 by 2020, which will still only be about 10 oz. of gold, about where we are now.

Aug 23 03:44 PM

[Jason Tillberg:]

The only way companies can grow earnings to meet those estimates as I see it, is with having pricing power. They have the capacity, by the capacity utilization of some 68% now, so companies are lean and mean. BUT, 85% of the American consumers are broke and are trying to pay down/default on their debts. 25%+ of mortgage holders underwater, losing their jobs, moving in with their parents, kids or shelters.

Also, wages are going down as are hours worked. Companies will in no way have any pricing power. Margins will be shrinking and may well go negative.

It does baffle me that market is missing this so dramatically.

Fall will bring a few dark clouds including swine flu hysteria, state government budget crises, a potential dollar crisis (unless we get some realization of write downs of loans on balance sheets in which case the dollar will soar again and tank markets) and the realization these earnings estimates just won't be met.

Aug 23 04:05 PM

[Jason Tillberg:]

very good article by the way.

Aug 23 04:05 PM

[untrusting ...:]

You are assuming that the US government will be able to maintain the low interest rates, massive liquidity and massive borrowing. That is highly unlikely, as the bond vigilantes and foreign lenders would have to support that. Much more likely that interest rates will have to rise pretty substantially just to be able to keep borrowing. If recent reports are any indication, even China is beginning to reign in liquidity and lending as they are becoming concerned about non-productive speculation and rising prices in stocks and real estate. The US government may well find it a lot harder and a lot more expensive to actually fund these massive deficits that they pretend at this point.


On Aug 23 03:44 PM lblaine wrote:

> As you said, the asset prices will continue to be supported by the
> huge liquidity in the system. With all governments stimulating their
> economies, maintaining artificially low interest rates, and virtually
> giving money to the banks, equities prices (in nominal terms) will
> continue to go up. With the US government committed to 10 trillion
> in deficits over the next eight years (these will at least be double
> that per prior government estimating prowess), the DJIA will easily
> reach 50,000 by 2020, which will still only be about 10 oz. of gold,
> about where we are now.

Aug 23 04:09 PM

[hopslover:]

Great article, keep in mind that the market can move either direction without supporting #s for a very long time. Some of those numbers from 05-07 can even be seen as manipulated because the s&p went from financials being the largest component to oil and we know how much that was overbid. Numbers can be manipulated for the financials now without mark to market. If the market moved in pefect sequence with earnings, it would be a lot easier. I hope that everything works out in the end.

Aug 23 04:41 PM

[whidbey:]

The overvaluation can last a long time in a momentum driven market. Months with any encouragement by authorities.

It will have to be a news event that sobers the crowd to P/Es of any stripe. I suspect that might happen when it is clear that Congress must raise the Fed debt level and that it will be due to the stimulus, Tarp and etc programs, that have not worked. Maybe not too, no one watches the debt levels but the foreign investors.

The market is living on borrowed time to produce earnings and it is hard to see where they will come from. Good comments .

Aug 23 05:34 PM

[Fighting Yoda:]

$ 73.05 S&P estimates are for bottoms up operatings earnings not reported. Reported earnings top down estimates for 2010 are much lower only $37.26, top down estimates even for reported earnings also are only $46.

So there are plenty of numbers out there to look at, user discretion adviced. Can $73.05 be achived unlikely - M2M plays an important role - anything can be reported. One way or other S&P is highly over valued for a bear market.

Aug 23 05:35 PM

[PVizzle:]

Brilliant Article! This is arguably the best financial article I have read in months.

Aug 23 08:05 PM

[Voice of co...:]

Excellent article and facts. I doubt very seriously if one of wall street's cheerleaders could compile such data. Of course, if they could and did, it would be more difficult to fleece the greedy, but incompetent lemmings.

Keep up the good work.

Aug 23 08:50 PM

[Smarty_Pants:]

Of course it remains to be seen exactly how the US gub'mint will manage to roll over nearly $12 Trillion of existing debt while taking on an additional $9 Trillion (or more) of debt. Already our foreign creditors have severely slowed their purchases of all debt American:

jsmineset.com/wp-conte...

Lacking foreign buyers in sufficient numbers will result in ever rising interest rates for US debt of all kinds, OR the foreign buyers will begin to demand that US debts be denominated in their home currencies to counter the risk of a dollar devaluation over time.

Either way, the end result isn't very pretty here in the US of A. We can't continue to borrow our way to prosperity, or out of the hole we dug in prior attempts to get there.

Aug 23 09:34 PM

[JPDewy:]

Excellent article and very insightful comments by all. All of these things (excessive debt, overvaluation on P/E, unemployment high and rising, forclosures high and rising, declining home prices, excess capacity) are well known by intelligent and informed investors-many are professionals.
Every analytical approach is cogent and unanimous that the Market is overvalued. And yet the Market rises!
Clearly-something else is the driver. What is it?
"Tis a puzzlement!"

JPDewy
No blog, no professional, no book.
No positions. Just curious and waiting.

Aug 23 10:34 PM

[perceptions...:]

Yes, the following estimate came in at 144.
www.chartoftheday.com/...
But, whether 117, 144 or something else, it would seem the consensus is that current stock prices, are well over, what is likely to be real earnings!

It would seem we are in a state of disbelief, between the old & the new. Between the old realities and a new paradigm!

That said, the world is in a constant state of change and our capacity to deal with that change, comes from an inquisitive mind.

Wisdom comes from our ability, to decide between right & wrong and courage, is our determination to proceed on the right course, no matter what.

We now need to look outside the box and find all the Wisdom & Courage, we can muster!

Aug 24 05:16 AM

[Ted Kavadas:]

The article (and comments) brings up several good points...

The valuation of the S&P500 is a very complex subject. As I recently wrote on my blog, the valuation seems to be implying a "V" economic recovery.

Should this type of economic recovery not occur, the downside could be rather pronounced.

Aug 24 11:00 AM

[Faisal Humayun:]

The other way of looking at things is what Dr. Marc Faber said..."The worse the economy gets, the higher the stock markets will go."...Thus, in a stock market which is more guided by government intervention you cannot predict the shape of economic recovery just going by the stock market trend...

Time will only tell where we head.

Aug 24 12:16 PM

[William M. ...:]

As I said prior to "Editor Approval"...great informational article, lots of good historical facts leading all to the logical conclusion the S&P 500 is overvalued by any historical P/E measures. More articles like this need to be "EDITORS PICKS" instead of those preordained "Top Contributors" cranking out high volume low quality content or those with prearrange marketing aggreements e.g. excessive ETF sales pitches under the cover of "Analysis"

Adding to your point the high USA Real Unemployment Rate a.k.a. under utilization rate of labor force estimated by the USA B.Labor Statistics is around 16.4% The American consumer spending has always been the largest stimulator to our economy and those dependent upon exports to American consumers. Yes, without Government spending and spending incentives GDP growth with not return to 3-4%.

A major issue I see is unlike the mild 2001 USA recession this economic hole will be much deeper to climb out. During the 1999 market peak USA unemployment was low. And during 2001 a little higher unemployment was offset by a Greenspan easy monetary policy and easy bank lending standards Yes, the combination created a real-estate bubble (in many parts of the world) but that bubble created a boom in housing and financial sector jobs. Today that's all gone and banks will maintain tighter loan standards. So even with the Fed giving money away at less than 1/2% the real-estate boom is over for a few years and unemployment will continue to remain much higher than the other two market peaks pointed out on the charts. In fact if we look back to the last American real-estate and financial crisis in 1992 today's P/E are even more overvalued.

So while there will always be individual stock investment possibilities rising from the ashes, this type of aggregate analysis, combined with the worries I point out, has caused me view this last 1,000 points a gift. Fridays DJIA 9,500 market was a perfect time to sell into the advance and move 50% into cash.

And lets not forget the 2001's Mild Recession ( 03/01-11/01) led to a V economy recovery but a W 2001-03 market as the market declined from March 2002 all year long before advancing all year in 2003. So, we could have a DJIA of 10,000 that then turns down for a 6-12 months in anticipation of a very weak recovery.

Aug 24 12:58 PM

[David Van K...:]

A few facts to be careful about when drawing conclusions from S&P's numbers:

(1) As of today, all 2010 earnings are listed as "Under Review" by S&P on the spreadsheet that they use to calculate earnings and P/E ratios. So the numbers stated in the article may be changed since the article was written.

(2) Even if all else stays equal, earnings will jump significantly in 2009-2010, because Q4 2008 will fall off the TTM (trailing twelve months) earnings calculations. Q4 2008 is significant, because that's when so many banks took huge writeoffs against bad loans that the earnings for the entire S&P 500 turned negative for that quarter. That quarter has been embedded in the TTM calculations ever since, driving up the P/E ratio (which is based on TTM earnings). That situation won't rectify itself until Q4 2008 drops out of the calculation, which will be some time during Q1 2010 (when companies finish reporting for Q4 2009).

(3) Some of the most significant contributors to 2008's terrible earnings, including the negative Q4 total, are no longer in the S&P 500. No fewer than 40 companies have been purged from and replaced in the S&P 500 in the past 12 months, including Lehman Brothers, Fannie, and Freddie. Unfortunately, S&P does NOT go back and restate past quarters' earnings to reflect the current makeup of the index. So backwards comparisons are sketchy, perhaps to the point of meaninglessness, and significant earnings jumps in 2009 and 2010 are to be expected just through index changes alone.

(4) The "earnings" cited everywhere, including in this article, are a derived number, not the actual earnings of the 500 companies. S&P adjusts the actual earnings (which you can see on the same spreadsheet under "Issue Level Data") to make new companies "fit into" the existing index without changing it when they swap companies. (The math is complex.)

Aug 24 04:22 PM

[Ted Kavadas:]

David,

You raise some excellent points. I would say that between the "computational" issues you raise, as well as other fundamental earnings issues and economic issues, there is a lot of uncertainty and ambiguity inherent in the numbers.

Two other issues (of many) that I think deserve some thought are the double-digit revenue declines many of these companies are experiencing, as well as "better than expected" earnings numbers that have been achieved through some rather severe (and possibly short-sighted) cost-cutting.

Aug 24 06:47 PM

[yapwk99:]

Hi there,

I was reading an article on Warren Buffet's acquisition of Burlington. The PE multiple cited for S&P 500 is only 13.4 (www.bloomberg.com/apps...
). I wonder what causes the difference between the report's and yours?

Also, for general public, is there a direct source we can access for the Indices' PE? I am rather confused. Thanks for your input.

Regards,
[e-mail]

Nov 03 08:32 PM