Intrinsic Value Of The S&P 500 (March 2017)

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by: Long/Short Investments

Summary

I use a discounted cash flow model to approximate the intrinsic value of the S&P 500.

I estimate that the S&P 500 is 16-32% overvalued in the base case.

Based on the level of risk-taking in the market, the equity risk premium has shrunk all the way down to 3.19%, below ~4.1% historical norms.

This comes out to forward real returns expectations of just 3.4%.

I estimate that earnings in the market would have to grow at 12.2% year over year over the course of the next five years to justify the market's current valuation.

General argument: The US equities market (as represented by the S&P 500 (NYSEARCA:SPY)) as a whole is probably overvalued by double-digit percentage points, but a repricing necessitates a clear catalyst, which isn't foreseeable at the moment.

Overview

Once per month, I assess the intrinsic value of the S&P 500 using a discounted cash flow model by incorporating the basic nuts and bolts of what drives its value. I do this mainly to help back out the type of forward returns expectations we could be looking at and to get a feel for how the current valuation compares historically.

With spreads between risk-free and risk assets approaching lows we haven't seen since 2007, we are at an interesting point in the market's history. Standard earnings multiples suggest stocks are the priciest they've been since the dot-com run-up, with the CAPE ratio promoted by Yale professor Robert Shiller suggesting stocks are the third-most expensive they've ever been, slightly behind 1929 levels and still 50% off where we were in February 2000.

The idea behind this isn't to definitively declare where the S&P 500 should be trading, as forward price expectations can vary considerably by individual. A market participant expecting 10% returns per year is going to price the market very differently from an individual expecting 5% returns. Moreover, investing philosophies differ considerably. I am more of a conservative value type, therefore my slant on the market will be fairly different from one who trades on momentum, trends, technicals, growth, etc.

For the discounted cash flow model used as part of this article, I use the following inputs from the market:

  • Current dividend yield
  • Current earnings yield
  • Expected cash payout ratio (the sum of dividends and net share buybacks as a percentage of earnings)
  • Earnings growth rate
  • 10-year US Treasury yield (used as a risk-free rate)
  • Equity risk premium (i.e., investors expected returns minus the 10-year Treasury)
  • Perpetual growth rate, set equal to the long-term real growth expectations of the US economy

As of March 1, the current dividend yield comes to 1.90% (2.01% last month). This figure is calculated by taking average dividends on a trailing twelve-month ("TTM") basis and dividing the amount by the current value of the index.

(Source: Multpl.com)

The earnings yield of the S&P 500 is presently at 3.71% (3.88% last month). This represents a seven-year low, and is the third-lowest on record behind the financial crisis and dot-com boom.

(Source: Multpl.com)

This value is derived from the same TTM approach, and will be the figure used in the discounted cash flow model. This figure is 44 basis points below where it was only three months ago, largely attributed to the market's rise of around 11% since the November US presidential election in anticipation of expansionary fiscal measures undertaken by the new political administration. The figure would be expected to normalize a bit once earnings catch up, assuming they do.

The cash payout ratio's role in this model is tricky given that it's been elevated ever since corporate earnings peaked toward the latter part of 2014. Management teams began buying back stock with cheap debt given the substantial spread between the cost of debt and equity. Normally buybacks only make sense when shares are undervalued and/or to better optimize capital structure. But a combination of cheap debt and a lack of alluring capital investment alternatives has led to cash payout ratios that are normally only reserved for crises.

It's rare that we see cash payout ratios above the high 80%'s outside of significant economic events (Japan in 1989, Russia in 1998, dot-com in 2000, financial crisis in 2008). But the corporate earnings recession that lasted from Q1 2015-Q3 2015 - when measured on a year-over-year basis - was added to that fairly select list, outdoing the ratios seen during '89, '98, and '00.

(Source: Moody's)

With that said, the cash payout ratio should be guided by historical norms. Even businesses that are obligated to pay out a certain ratio, like real estate investment trusts (90%), usually only do so by diluting existing shareholders with a continuous stream of new equity issuances.

It's very difficult to keep a business growing by only plowing back 15% or less of earnings. Moreover, paying out more than 100% of earnings is not sustainable long term, and is typically indicative of emergency circumstances, such as an earnings recession where the retained earnings account and/or debt capital markets are tapped to avoid a sell-off in the stock.

Payout ratios approximate around 75% long term. I've done 80% for these estimations in prior months. Each five percent increase in the payout ratio will expect to increase the index by 6-7%.

Private non-residential fixed investment has lagged in the US, which has meant more capital has been allocated to capital structure adjustments. This metric recently barely emerged from a four-quarter recession when measured year over year.

A continuation of higher payout ratios could be justified in the short run if fixed investment growth remains tepid. With equity markets fundamentally valued on the present value of the cash that can be taken out of the companies that comprise the given index (in accordance with the weighting specifications of the index), higher payout ratios can validate a higher reading for the market as a whole.

(Source: U.S. Bureau of Economic Analysis; modeled by the Federal Reserve Bank of St. Louis)

In the discounted cash flow model used for this exercise, I've set the cash payout ratio to 80% - a rate that is sustainable, yet still above trend.

Earnings growth is quite variable and difficult to predict year to year. It was previously negative for seven consecutive quarters measured year on year, but recently recovered to a 3% y/y figure in Q4 2016. Naturally, the recent strong run in US equities is banking on earnings growth in the coming quarters as well. This will predominantly be derived from deregulatory initiatives and corporate tax cuts down a level more in line with other developed nations. The anticipation is that this will not only boost earnings due to a simple drop in the nominal rate, but rather, will help onshore more corporate activity by balancing the taxation landscape to shore up a basic competitive pitfall in the pre-existing tax code.

Since Q1 1990, earnings growth has approximated 8% as a median figure. Forward-looking growth rates take into account a 1.8% long-term economic growth rate. Even if we were to assume that earnings growth comes to 12% in year-over-year terms from 2016-end to 2017-end (above trend), and thereby converges to the long-run growth rate of the economy over a period of twenty years, this would place the compounded average at 7.1%.

(Source: Author)

As a result, I've used 7.1% as the earnings growth estimation, but this variable is one that should be sensitized to various figures to produce a valuation range.

The 10-year Treasury rate was 2.46% after the market close on March 1, and this a value I expect to remain relatively range-bound for months to come. The Fed is in the midst of a tightening cycle, though the path is likely to remain gradual.

A higher 10-year Treasury will work to lower the valuation, given the way in which it raises the discount rate used to value corporate cash flows. Relative attractiveness is also material when it comes to valuation, as investors are always rationally inclined to seek out the proper balance between risk and return. Higher Treasury yields, which generally provide the foundation off which fixed-income is priced generally, reduce the relative appeal of stocks and can decrease equities valuations on a flow of funds basis. It is all nonetheless contingent on the level of risk aversion in the market.

The equity risk premium is one additional sensitivity parameter, as it helps to back out forward returns expectations in the market. The equity risk premium of the S&P 500 has historically trended around an average of 4.1%. The value is defined as the annual average of the S&P 500's returns (earnings yield plus dividend yield) minus the year-end 10-year Treasury bond yield.

Methodology

As stated, this valuation exercise is done using cash flow. Accordingly, to derive the projected cash flow for each year, we need to take the expected earnings yield and multiply it by the expected payout ratio. This gives us a measure of how much cash is being released to the owners of the business (the stockholders).

This is completed for each year of the projection period, where I do five years in total. These cash flows are discounted back to the present by using a discount rate equal to the sum of the equity risk premium and the 10-year Treasury yield taken to the power of whatever year in the future we're estimating.

After the five-year projection, we calculate a terminal value. This is taken as the expected cash flow in what is basically a sixth year, i.e., the expected earnings in the fifth year of the projection period multiplied by the long-term growth rate of the economy. This is then divided by a discount rate calculated as: 10-year Treasury yield + equity risk premium - the expected perpetual growth rate of the economy

Using this discount rate, the terminal value calculation can then be discounted back to the present. This value is then added to the present value of the other cash flows to obtain an intrinsic value for the index.

The 10-year Treasury yield is higher than the expected real long-run growth rate of the economy, which should normally be true. However, in this age of widespread massive-scale quantitative easing, it has often not been. This has served the purpose of compressing the aforementioned discount rate, boosting equity valuations, and attempting to create a windfall of wealth that is spent back into the economy.

In the US, the 10-year yield has gone about 65 bps above the expected long-term growth rate (or, to be more precise, the Fed's publicly stated long-term growth beliefs). In terms of investor behavior, this resultant compression of the discount rate means higher bond yields without a concomitant increase in growth will create higher returns expectations for stocks.

Results

If we adjust growth expectations by +/- 150 bps on each side of the 7.1% figure mentioned above, we would obtain a valuation of the S&P 500 index at 1,810-2,060, which would place it at an overvaluation of 16-32%.

If we change some of these assumption to reflect a more bullish stance, we can try the following:

  • Upping the long-run growth rate to 2.0% (from 1.8%)
  • Increasing the cash payout ratio to 85% (from 80%)
  • Discount at an equity risk premium of 4.0% (down from 4.1% to reflect greater risk appetite)
  • Increase the earnings growth to 10% year over year for the next five years

This would place the index at a valuation of 2,320, or just 3-4% off the current level.

Investors' Returns Expectations

If we were to sensitize the current value of the index to the equity risk premium using our base assumptions, it comes in at just 3.19%.

(Source: Author)

The 3.19% figure is 74 bps lower than the figure calculated from late September and 59 bps lower than the pre-election figure. This is a massive difference and illustrates the level of confidence that the market is putting into stocks at the moment from a combination of future expansionary fiscal policies and accommodative central bank policies. Real interest rates are -1.9%, taking into account 2.5% headline inflation and a 0.625% effective Federal Funds rate.

In terms of historical returns, from February 5, 1971 (the first day the S&P 500, Dow Jones (NYSEARCA:DIA), and NASDAQ (NASDAQ:QQQ) traded simultaneously), the S&P has yielded 7.18% annualized; the Dow Jones has yielded 7.09%, and the NASDAQ 9.23%.

These figures are inflation-adjusted and consider dividend reinvestment. At a 10-year yield of 2.46% and with core inflation at 2.3%, this would suggest about 3.4% in real returns moving ahead (2.46% Treasury + 3.19% equity risk premium - 2.3% inflation).

If we were to assume 10% year-over-year earnings growth over the next five years (i.e., earnings would be 61% higher in February 2022 than they are currently), this would produce an equity risk premium of 3.69%, which would generate forward real returns expectations of approximately 3.9%.

Given the US is in a relatively advanced state with respect to its economic development, with demographic headwinds and slowing innovation, it's probably unlikely that US equities will continue to return 7.2% per year as they have averaged over the past 46 years. Where the market is currently at its near-2,400 mark, above-trend earnings growth at 10% y/y would still suggest that equities are expected to return 330 bps below their historical norms moving forward.

Even if we boost the earnings figure to 12% y/y over the next five years (i.e., earnings 76% higher in February 2022 than their current levels), the resultant equity risk premium would still be slightly below historical levels at 4.07% and produce forward real returns at just 4.2%.

If we sensitize on the basis of year-over-year earnings growth over the next five years, we get the following outputs:

(Source: Author)

Accordingly, even if we afford the projection very bullish assumptions, it still suggests a very crowded equities market toward the long side and relatively poor risk-to-reward fundamentals.

Conclusion

Historically, the market will naturally look very overpriced, but with the sheer oddities of modern-day central bank policies in developed economies, we're in a historically unique period in the market's history. A combination of expansionary fiscal policy initiatives, a high risk-taking appetite, and overnight interest rates that are -190 bps in real terms have led to the distorted valuations we see currently.

Ultra-low interest rates and trillions of dollars' worth of quantitative easing have been the norm over the past 8-9 years in the US (longer in Japan, and a bit shorter in the euro area). These policies have bid down bond yields to highly unattractive levels, and forced market participants into the far extremes of the risk curve by massively bidding up equities and real estate beyond their traditional fundamental bounds.

Sub-4% real forward returns are not optimal, but inflation's rise has kept fixed income out of vogue given the way in which rising prices erode yields. Stocks, still in today's circumstances, provide close to 6% in nominal forward returns. The entire "TINA" (there is no alternative) principle continues to hold true.

My personal median expectation places the S&P's value at around 1,930 - a level that hasn't been seen since February 2016.

This is nonetheless not an argument to short the index, and I think a bullish intermediate stance can continue to be justified due to a lack of an immediate catalyst and as a basic consequence of a lack of suitable, decent-yielding alternatives. Value investing has become very difficult to do, which means either greater allocations into other asset classes and remaining underweight US equities (I've been underweight since the 2170 mark in August 2016) or finding alternative methods of extracting value, such as corporate events and special situations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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