I look at a variety of stock market valuation methodologies. Below are several, but I look at many
others as well to get a sense of valuation.
Of course, valuation means absolutely nothing in the near-term. It is, however, the single biggest
determinant of long-term returns in the stock market.

Assuming, of course, we do not go the way of Argentina.

One model I use is a forward price/earnings model. I calculate normalized earnings by
multiplying a normalized profit margin by sales per share, assume 6% profit growth for
the next 20 years – which is the long-term growth rate for earnings – apply a
multiple of 15x – which is the
long-term average PE of the market – then discount this 20-year expected
S&P 500 target back to the present to calculate the expected capital gain.
I then add the current dividend yield to get my total expected return. Currently, this model is forecasting a
total return to equities over the next 20 years of 6.7%, well below the
long-term average of 10%.

Another model is a dividend model. I forecast normalized earnings one year out and multiply it
by an expected payout ratio – which is higher than the actual current payout
ratio. I then add the long-term
growth rate in dividends. This
model is forecasting expected equity returns of 6.3%. (For the record, the current dividend yield of the S&P
500 is 1.8%. The dividend yield for
the S&P 500 never went below 2% before 1997, around the time when markets
started going bonkers.)

Modeling has its problems, of course. Just like all valuation methodologies, I
use models for approximation, not precision. I’m not trying to hit a hole-in-one. I’m just trying to hit the green. (*He can’t keep the ball on the fairway.
– ed.*) And the approximation is
that stocks are expensive.

I also use a normalized PE. Normalized earnings is calculated in the same way as above. Sales
per share of the S&P 500 is currently $905. Assuming a normal profit margin of 7% - the average of the
past 20 years has been 5.5% - normalized earnings per share is currently $63. Thus, the market
multiple on normalized earnings is 18.5x, well above the long-term average of 15x.

Trailing earnings are currently $53, forward “operating”
earnings are $77. Wall Street
consistently over-estimates operating earnings relative to reported earnings by
10% to 20%. If you adjust for Wall
Street’s excessive optimism, forward earnings are $62 to $70. Using these two numbers, the market is
trading at 16.7x to 18.8x forward earnings. While the trailing historical PE multiple has averaged 15x, the forward
PE has averaged 14x. That means
the market is 19% to 34% over-valued.

If one looks at analysts’ estimates for individual companies, the median forward PE
of the Russell 3000 is 15.9x.
Since this is operating earnings, we have to adjust by 10% to 20% to obtain reported earnings. Thus, the median PE for companies in the
Russell 3000 is 17.7x to 19.9x. Given that the historical forward PE has been 14x, the market
is 26% to 42% over-valued.

In the asset-driven economy, where the Fed has unleashed oceans of liquidity, none of this matters. The market is riding a rising wave. But when the wave starts to break – when the liquidity starts being withdrawn – it will matter greatly.

"I use models for approximation, not precision."

Given your 6.7% versus 6.3%, both of which I like much, I find your disclaimer of "precision" unnecessary.

"...when the liquidity starts being withdrawn..."

If only.

Please help because I see no likelihood of this ever again.

Posted by: psychodave | April 01, 2010 at 09:27 AM

What discount rate do you use?

Posted by: Pedro | April 01, 2010 at 09:41 AM

Shiller p/e 10 compels the same conclusion.

Posted by: John L. Grant | April 01, 2010 at 09:27 PM

No matter how one values equities, I can not see a reason for a cyclical period for equities trading at high P/E's. Inflation, as we know it, appears to be a way off though neo-inflation could be right around the corner it would dampen demand. A controlled weakening dollar would of course help mantain high P/E's but, the USD is the least ugly (for now at least) among paper, so I expect the dollar to increase in value for awhile. This a far from a cyclical recession and recovery.

Posted by: Mark G. | April 04, 2010 at 10:33 AM