Monday, September 30, 2013

The Market is Fairly Valued!

So this valuation thing has been nagging at me all weekend so I just decided to take a quick look at something.  Since the S&P 500 index is too big and unwieldy and I don't have access to data, I just decided to take a look at the Dow.  Last time I looked at margins (to see if margins are too high and unsustainable), I picked a bunch of big, blue chip names that popped into my head.  

This time, I wanted to be more objective and not do that.   So I figured why not look at the Dow Jones Industrial Average components?  It's not a great index as it's price weighted (which is ridiculous), but it has been highly correlated to the S&P 500 index over long periods of time anyway.

So I just googled Dow P/E ratio and up popped this page from the Wall Street Journal:

I almost fell out of my chair.  14x P/E for the Dow 30?!  No way.  I suspected this had to do with the price-weighting of the Dow (again, how ridiculous and arbitrary!) so I punched in some numbers on the spreadsheet and sure enough, if you just add up the prices of the component stocks and divide by the sum of the EPS, you get a P/E ratio of around 14x

But nobody is going to buy that as representative of a broad market index valuation. 

So I calculated the simple average of the P/E ratios of each component stock.  I used the last twelve months EPS of each component stock as listed in the recent Barron's.

Last Twelve Months, Current and Next Year P/E Ratios

Sure enough, if you calculate a simple average of each P/E ratio, it comes out to 18.5x; a bit on the high side and certainly not cheap.

Just out of curiousity, I typed in the current year analyst estimates for each component stock (from Yahoo Finance).  We all know analyst estimates can be wildy inaccurate.  But since we are already almost done with the current year, I figure the December 2013 year-end estimate can't be all that bad.

Using current year estimates, the P/E ratio of the Dow 30 (using a simple average) comes to 15.11x.  That's totally reasonable and I would consider that 'fair' for sure.   The Dow is not expensive at all.  Sure, 3Q and 4Q can come in lower than recent estimates but since 1Q and 2Q is already in the can, it can't change this figure too much unless we have a disastrous 3Q and 4Q.

The last column on the spreadsheet is certainly questionable.  It's the analyst estimate for December 2014 year earnings.  Earnings estimates for a year that hasn't started yet can be off by a lot depending on how the year develops. 

But that figure, for what it's worth, comes in at 13.74x earnings. 

I just took a quick look at the inside of an index to see where the overvaluation might be.  The macro charts seem to show expensive stocks and above trend earnings but for me the problem is that it just doesn't feel like it.  Other than a few pockets of mania, I just don't get the sense that people are rushing into stocks.   The economy too is slow growing so it doesn't feel like corporate earnings are above trend (I know they are, but it just doesn't feel like a corporate earnings bubble).  I know interest rates are low so that boosts corporate profits as it lowers interest expense, but it feels more like corporations are suffering from low rates as they are flush with liquidity.

Yes, the Fed pump priming (and others around the world) and fiscal deficit is highly stimulative, so earnings probably are higher than they would otherwise be.

So it's a little strange to me.  People seem to hate stocks (rushing into alternative assets), and yet valuations are a little bubbly.

Having done this exercise, I can see how the market can be considered fairly valued.  If you look down the list at each component stock, each one seems to me more or less reasonable.  Not cheap, but not expensive either, except for maybe Nike, Home Depot and Visa.

Is this a picture of mania in the stock market?  To me not at all.  Coca-Cola at 40-50x P/E was indicative of something, but I don't see that sort of thing in the above table.

Sure, maybe corporate earnings come down.  But if it comes down from current year estimate levels, the market may not be as wildy overvalued as some charts seem to indicate.

I just throw this out there as a thought, not an answer.


  1. Doh, so I find this after I do all the work, lol... but here is Barron's Dow info:

  2. Am I crazy or does the WSJ's R2000 P/E seem justttt a bit high?

  3. lol, I don't know. See, that's the problem with these stats. Sometimes it tells you something, sometimes it doesn't. Who knows WHY the R2000 P/E is so high. I can tell you for sure that MOST stocks in that index do NOT trade at that level. Maybe some big firms had big writedowns that offset much of the earnings of a bunch of smaller companies. You really have to look under the hood to understand what drives these figures.

    That's sort of why I am not too big on doings things because of this or that market index p/e level... It will often lead you astray!

    1. There are a lot of companies in the R2000 with negative earnings so when you look in total you get the large PE. Personally I think R2000 is pretty expensive, large caps not so much

  4. An issue with looking at and comparing LTM or historical P/Es versus forward looking P/Es is that analysts tend to look at "operating" earnings which exclude "non-recurring" charges and such. LTM or historical earnings tend to be calculated on a "reported" basis. So there's a potential apples-to-oranges comparison at work that's worth considering. As far as I know, long-term forward operating earnings data isn't available, but I've read that the appropriate average P/E for the comparison is closer to 11x. So even a mid-teens figure for the forward P/E put in this context is somewhat elevated.

    1. Good point. I've heard a similar argument about that but haven't seen figures. I think Goldman and others on the street us operating net earnings in their market valuation models, although they are probably not forward estimates (going back).

      Anyway, I really don't know the answer to these questions. It's not my thing, really, and as I said it doesn't impact what I do although I like to be aware of it.

      Either way, the above tables don't cause me alarm so that's good. I do understand that earnings may be bloated by all this money-printing etc... so I am aware of that too. The time to really worry, I suppose, is if these multiples get really high on top of these bloated earnings. That's when you get the bubble (as we saw in 2000 in some sectors, not all, and Japan in 1989).

      Thanks for reading.

    2. First off I love this blog...great stuff. I am like you in that I don't really like to put any credence on PE ratios and overall market valuation. The "E" represents only 1 year of earnings and we all know that the value of any security is the future discounted cash flows from here to forever. The challenge I see going forward is actually aggregate earnings growth. I'm sure you've read arguments that profit margins are at all-time highs etc. There's something to be said for this. Also likely related to this is abnormally low interest should question how sustainable these really are and the subsequent impact on earnings as these rates normalize. Anyhow, I thought I'd send you a link to research done by a firm called Crestmont....they do some interesting macro valuation work. Here's a PE Report they frequently publish (as of Q1 2013). Again, thanks for great blog.

    3. Thanks for posting. The P/E report is pretty interesting. I agree there is something going on with margins at record levels. I really don't know what to make of it other than that we have to temper our expectations on earnings growth over time and stock returns. That's for sure.

      If you look at the long term p/e and earnings trend charts, it looks like you could have made money getting out in 1965 etc... but the question is if you got out then, when you would get back in?

      My whole argument is that even given this truth about stock market cycles, I still haven't come across anyone that has created an impressive track record using this information. The people that have tended to have the best track records tended not to get in and out of markets.

      I don't doubt that the market will go down a lot eventually. This is inevitable.

  5. Good post. In my opinion, stocks behave like carry instruments. Over the longer run, if you adjust for earnings volatility, as long as there isn't a recession / recovery, (i.e. we are in the expansion part of the business cycle) the S&P has tended to go up ~1x PE a year. If you look at stock price behavior that way, it's not a surprise that stocks got to such rich valuations in the late 90's, given how long the expansion lasted.

    Anyway, I agree that stocks are not especially expensive, and it seems that Buffett does as well, based on his comments.

    One other point to consider, since we're going through this macro exercise. What if yields never "normalize" in the next decade? People seem to be mostly focused on what happens to stocks if 10y yields hit 5%. Well, what happens if 3% or 3.5% turns out to the the yield high for this cycle? That's a view that's certainly not priced in and not unreasonable.

    1. That's a good point. It's now a no-brainer that we will get inflation and interest rates will go up. That's been a no-brainer in Japan for 20+ years. So you may be right. Yields may not go up as much as we all expect.

      Thanks for reading.

  6. What do you think about the very high Tobin's Q?

  7. I don't know. I've heard that argument for as long as I've been in the business; that the market is overvalued due to a high Tobin's Q.

    Let's put it this way. Let's say you are having dinner with Buffett and you asked him about the high CAPE and Tobin's Q ratio. He would tell you that things like that are fun to look at, but never entered the equation for Buffett when he invests. If he sees something he likes, he's going to buy it regardless of what the Tobin's Q ratio or CAPE 10 is.

    I feel the same way.

    Another example of the difficulty of using these measures is to look at the dividend yield going back 100+ years. For a long time since the late 80s and early 90s, people have been saying the stock market is overvalued because the dividend yield is below 4% or 3%. They said it's ludicrous, and that dividends is the only thing that comes back to the shareholder. The dividend yield has never gone back up, ever.

    I'm not saying it never will, or that p/e ratios will stay at 20x forever, or the Tobin's Q will stay high forever. I doubt that too; that sounds too Irving Fisher-like... But we can't know how long something can stay high (like we don't know how long dividend yields will stay this low).

    Buffett made an interesting comment the other day on CNBC. It's not related to this topic but was sort of is. When they were discussing tapering, Buffett reminded everyone that the Fed balance sheet might stay at this level for a long time just like the Fed balance sheet stayed at $1.5 trillion for a long time; he said the Fed b/s might be at this level five years from now, for example.

    So the valuation 'problem' may persist for a long time. I think the market has been deemed overvalued by many since the mid-1990s.

    Anyway, this is certainly an interesting question and I like to think about it sometimes, but I probably spent way too much time on this already, lol...

    Thanks for reading.

  8. kk,

    Looking forward to reading your thoughts about JPM.

    Is it me or did Dimon's voice crack at one point? It's probably me. I got the impression they will not agree to penalties relating to B.S., or at least any wrong doing because he repeated more than once that they will only accept fair and reasonable and he didnt think that's reasonable.

    Another thing recently there was more than one articles on the WSJ accusing the AG of being overly aggressive and even trying a bit of a personal attack mentioning his own personal benefit from this (both the Greenberk op-ed and the followup letter). Do you reckon such media attention (obviously, not something coming from greenberg...) can make a difference?

    Anyhow, really looking to hear what you think about current situation.


    1. Hi,

      I didn't notice Dimon's voice crack, but he must be really frustrated. I think the government is doing too much and agree with Greenberg. It's a bummer what is happening, but they will get through it.

      What was really interesting to me of Dimon's comment is when he said that sure, new regulations and capital requirements will impact earnings (lower leverage etc...) but that is before accounting for optimizing business lines, repricing in the industry and things like that. It seemed to me for a while that most people tend to do a linear, static analysis and don't think about the changes that may occur in the industry to offset the new environment.

      A great example (or a horrible one in another sense) is when brokerage commissions were deregulated in the 1970s. People thoguht that the securities brokerage industry was toast after that, but as we now know, that was the beginning of a 20-year, historical bull run in stocks and the industry... You couldn't have been more wrong. The mistake was that people didn't realize that the securities industry is dynamic and can change/adapt to new environments. If you only look at trading volumes and fixed commissions, then a linear, static analysis would have in fact predicted the demise of the industry.

      Anyway, we'll see what happens with JPM. I'm glad to hear that JPM is almost out of the woods, though...

      JPM and other banks might be classic value investing special situations now; earnings are depressed due to one-time (and extended) legal and other legacy costs from the crisis... Once this lifts, then the profitability of the good banks may come through and the market may finally start to price that in.

      Of course, this may not happen, but it looks like a good possibility.

      Thanks for reading.

    2. kk,

      Thanks for your insight about how dynamic the future is, I guess this is where qualitative judgement comes in and where there's a bit of concern: it didn't work out that well for Greenberg, did it. What if Dimon have to leave, does JPM have someone else that can achieve similar ROE?

      And, trying to apply what you said (combined with my optimistic bias) -- they have added and will add thousands of employees and many millions in costs to "reduce risk". This can be discounted if it means it will help them avoid costly mistakes in the future. The question to you would be if setting such a system in place can indeed reduce risk and increase profitability for the bank or does it add a bureaucratic layer which makes things worse?

      Thanks again


    3. I don't think this is the same situation as Greenberg, but who knows. Frankly, I probably wouldn't own JPM without Dimon but I tend to think they have a deep bench so they should do well post-Dimon, at least for a while.

      The added layer of cost/bureaucracy is a factor for sure. I don't know if it will make things worse or not. If it's necessary, then it's necessary so there's not much choice. If it leads to a better company over time from a legal / compliance point of view, it should be positive overall in the long run.

      Thanks for reading.

  9. Thanks for an interesting post!
    I was just trying to reconcile some of the data you took from Barron's. LTM EPS for GS and PFE seem to be quite far off (current year estimates you took from yahoo finance seem to be closer to actual). Not sure about other companies, just checked these two as current P/Es seemed to low.
    Anyways, disregarding this, interesting thoughts in the article!
    Thanks, Dalius

    1. Yeah, I just took those straight from Barron's and didn't check myself. But the gist of the message is still the same.

      Thanks for reading.