Do Low Multiples Indicate the Market is Undervalued?

S&P 500 is trading at low price multiple to expected earnings, 13.7 according to WSJ. The historical forward P/E has been in the range of 14-16, depending on how far you look back. With interest rates incredibly low, 3.88% on the 10-year, should make the fair-value multiple even higher.According to my calculations, the S&P 500’s mean P/E = 14.2 and median = 13.2.

Thirteen companies were excluded due to negative earnings. The highest P/E was 90, and only ten firms had multiples greater than 30. The chart shows the frequency distribution of the individual firm’s P/Es constituting the index.So is the market cheap? The low price multiples suggest that it is.

The Consensus estimates point to a strong recovery. According to Thompson, Analysts predict earnings to jump 15.3 percent this year.

In my opinion, that magnitude of growth is wildly optimistic. The market isn’t buying it either. It’s not that the market is cheap, it’s that investors believe consensus estimates are too high. Why do I think that? Because if the market had full confidence in the forecasted numbers, I doubt the market would trade at these multiples. Hence, investors are pricing in lower earnings than the consensus forecasts, thus making multiples higher.

The most probable outcome will be downward revisions to the earnings estimates. It’s possible that some of the consensus numbers are stale, meaning analysts have been slow to update them. This seems plausible given the current environment of uncertainty, and the inherent lack of visibility, may delay updates to estimates. In some cases, analysts may be waiting for a clearer picture going forward, or updated guidance from firms before making revisions to this and next years’ full year estimates.

Another possibility is that the required rate of return investors demand from equities rose, the “Equity Risk Premium.” This implies that the market perceives increased risk inherent in the equity markets. This seems plausible since volatility has increased relative to years past. Higher perceived risk leads to higher demanded returns which compresses price-earnings multiples.

In my opinion, stocks are not as cheap as forward multiples suggest. Earnings estimates are too high and are likely to come down. In addition, the ERP has increased pinching multiples. However, if the economic slowdown begins to appear less severe as the market is expecting, then stocks would be rather cheap. That would mean that analysts are not overestimating future earnings. However, given the turmoil in the housing market and the relationship to consumer spending, it’s likely the coming quarters will be weak.

Comments

[Donald Johnson:]

I totally agree. Every investor should read this article. Historically, I think, analysts' estimates are inflated beyond a quarter or two and have to be revised lower near the end of calendar and fiscal years. That is quite likely to happen during the next 12 to 24 months. And a recent study noted that many companies do not do a good job of forecasting their results. This is either because they don't invest in the people and technology needed to produce good forecasts, or they're in markets that are so volatile that they are unpredictable.

How good is the guidance provided by the 2,500 leading companies? How good are the forecasts published by analysts, and how biased are the analysts' reports toward selling stock rather than helping traders?

Fortunately, contributors to Seeking Alpha are trying to help traders make sense of the outlook for individual stocks, their sectors and the markets.

2008 Feb 21 09:49 AM

[epicahab:]

To date nobody has been able to predict where the market is going for hundreds of years. Stop trying.

2008 Feb 21 11:27 AM

[David Barsan_:]

Thanks for the article, Turley. I definitely think the ERP comments seem to be very true these days.

2008 Feb 21 12:19 PM