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  • 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.

Source: S&P 500's Justified P/E Ratio