S&P 500's Justified P/E Ratio

Jul.16.14 | About: SPDR S&P (SPY)

Summary

Operating P/E is at 17.6.

Reported P/E is at 18.95.

Are these too high, low or just right?

In an earlier article, I made a case that the reported earnings of the S&P 500 (NYSEARCA:SPY) are a better indication of the earnings power of the underlying index. That is, that the "correct" trailing P/E to use was closer to 19, rather than 17.

Now, we come to the part to check if a P/E of 19 is too high, low or fairly valued. One starts to do this by using the "justified" P/E formula

b = earnings retention ratio (so 1-b is dividend payout ratio)

g= growth rate

r= required return

If one wants the leading P/E then the formula is reduced as follows:

One can use this link for further explanation or one can Google "Justified P/E." We can find the data from the S&P indices web page and download it as an excel file, just look under "Additional Info" and then "Index Earnings."

For Q2, 2014, a dividend of $9.76 per share is given. We'll accept the estimate of reported earnings of $27.70 a share (top down). This means that 1-b was equal to 35.23%. From Q1 1998 until Q2 2014 dividends grew at a 5.761% rate; therefore I will use this for g. r is a bit complicated to come by. There are several ways to estimate it; use the CAPM model, a multi factor model, or an equity risk premium added to the bond yield.

I will use the equity risk premium added to the bond yield method. Data shows that from 1928-2013 the arithmetic risk premium of stocks over the 10 year US Treasury was 6.29%. On the last day of Q2 2014 the 10 year UST rate was 2.53%, thereby, making r = 8.82%, which is close to the double digits that many investors seem to expect.

In summary:

(1-b) = .3523

g = .0576

r = .0882

Plug these figures into the first equation and the result is 12.18. With the current P/E at 19-ish this would indicate that the stock market is overvalued.

Next, there still is the leading P/E to consider. Plugging the same numbers into the second formula gives a justified leading P/E of only 11.51. The data provided by S&P Indices shows an estimated reported earnings in Q2 2015 of $122.40 and the close of the S&P 500 was 1960.23 for Q2 2014. This gives a leading P/E of 16.01. The results still show a market that is highly valued.

Now, bulls might holler and claim that companies are buying back shares and that is like a dividend. While this is true, the current rate of buybacks compared to earnings creates problems, which I will analyze in my next article. In the mean time, for investors who use discounted cash flow methods, realize that risk is higher than normal.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.