PMC Weekly Review - April 8, 2016

A Macro View – Valuation Confusion

As the stock market pulled off another dramatic, V-shape turnaround, and the S&P 500 Index is once again within striking distance of its all-time high, the discussion has intensified as to whether or not the stock market is overvalued. Although valuation is never a good market-timing tool for short-term traders, price does matter, especially for long-term investors.

Much confusion exists on how to value the stock market. Different market commentators use various valuation measures, whether due to their diverse schools of thought or their dissimilar views that support their own interpretation of the market. For example, someone making a strong case for the market being grossly overvalued will use the most conservative earnings measures, such as normalized or inflation-adjusted earnings. On the other hand, those aspiring to convince the public that the market is cheap may rely on more “lenient”, or growth-oriented earnings measures, such as EBITDA or out-year earnings projections.

The most readily accepted measure for valuing the stock market, and rightfully so, is the Price-to-NTM (next-twelve-month) consensus earnings estimate. For example, if the S&P 500 Index stands at 2000, and the NTM consensus earnings estimate is $120 per share, the stock market is valued at 16.7 times forward earnings.  This figure is slightly higher than the long-term average of approximately 15 times forward earnings.

Another widely used measure is Price-to-LTM (last-twelve-month) earnings. Since investing in the stock market is based on a company’s future earnings, this backward-looking measure is not considered relevant for decision making.  That is because it generally overstates how expensive the market is, as aggregate corporate earnings generally grow year after year.

It is worth mentioning that NTM consensus earnings are a recurring, pro-forma earnings estimate that excludes one-time items, such as write-downs or write-ups of asset values. These earnings are not strictly compliant with GAAP earnings, and pro-forma numbers do not have a good reputation (as some corporate crooks have abused them to mislead investors). But it is appropriate to use them for a stock market comprising hundreds, if not thousands, of companies, as one-time items of a host of them tend to offset each other, especially over time.

The S&P 500 Index consensus earnings estimate currently stands at $119 per share for 2016, and $135 per share for 2017. At the April 7 close of 2041.91, the Index trades at 17.2 times 2016 consensus earnings estimate. It is no doubt expensive, but if the 2017 estimate of $135 per share holds (+13.4% growth over 2016), the multiple will drop to just 15.1 at year end, based on the Index’s current level, and close to its long-term average. Of course, the consensus earnings estimates for 2016 and 2017 are anything but certain, since they are subject to frequent (if not significant) revisions as the macroeconomic environment evolves and companies update their earnings projections. They are imperfect, moving targets, but they do provide a rough estimate of how cheap or expensive the stock market is.

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