David Beard's  Instablog

March 11^th, 2010

“Neo, it’s the question which brought you here” – Trinity – The Matrix - 1999

Revenue growth continues to climb, estimates are moving up and stocks could climb much higher. Despite a near record up days in the averages, which should foreshadow a pullback, maybe, just maybe the market is sniffing out the following scenario.

Credit goes to my friend Nick Colas, Chief Market Strategist at BNY ConvergEx Group for analyzing analyst revenue expectations for the stocks in the Dow Jones Industrial Average. His analysis shows that bottom’s up research analysts expect a 13% y-y top line growth for the first quarter 2010, versus just a 6% increase for the same quarter back in September 2009. Growth looks stronger x-financials, now estimated to be +8% y-y by the 4q2010E.

So I decided to look at the S&P 500 expectations, as compiled by Bloomberg. Interesting 2011 revenue estimates call for an 8% increase y-y, with costs up about 6%, driving a 15% growth in EBITDA and boosting earnings up 20% to $94/share. For those who find it hard to believe in such operating leverage, let’s walk through an example: Assume base revenues are 100; the P/L would look like this:

                                Current Year           Next Year                                change

Revenues               100                          108                          +8% (+2% consumer spend + 3% inflation +10% capex/exports)

Cash Costs            82                            87                            +6% (3% inflation plus new hiring)

EBITDA                   18                            21                            +17%

EPS                         $78                          $94                          +20%

These expectations might not seem aggressive, even to a bearish investor who expects a muted, slow recovery. Let’s start with +2% real consumer spending for 2011. Add to that 3% for inflation and you get 5% growth for the consumer sector of the economy. Assume that capital spending and exports, which got hit the most in the recession, grow10% and its’ not a stretch to meet the 8% top line growth assumptions for 2011.

If these expectations were to hold true, and we used the old “rule of 20”, meaning the P/E of the market is 20 minus the inflation rate. This rule of thumb has worked pretty well over a long period of time, even when inflation was running double digits. So if we assume inflation runs 3%, the SPX could trade at 17x $94 = 1,600, up about 40% from current levels.