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Valuing the Market

roller coaster

By Art Rothschild and Joel Dresang

Watching stock prices roller coaster can result in dizzying decision-making for investors. Yet, many individuals are inclined to increase or reduce exposure to the market based largely on which way they see prices headed at any given moment.

Wise investors know they have better tools than just prices to determine more objectively the relative value of the market.

One important measure is the Price-Earnings (P/E) ratio – also known as the P/E multiple – which offers a sense of how much you’d be paying for a stock’s earning power.

The P/E is widely available at financial news sites, but you can figure it out by dividing the stock’s current share price by its annual earnings per share. Use the reported earnings from the most recent year to find the trailing P/E, or use analysts’ earnings forecasts to get the forward P/E.

Once you know a stock’s P/E, you can compare it to similar securities or historical or projected multiples.

Say a stock is selling for $60 and its earnings per share was $4, then its trailing P/E would be 15. If its projected earnings for this year is $6 per share, then its forward P/E is 10. The higher the P/E, the more expensive the earnings. So if similar companies have a multiple of 8 times their most recent earnings, the stock in our example with a P/E of 15 would be pricey.

Market applications

Applying this exercise to the market overall, we can see that stocks broadly have been at relatively low prices lately.

The Standard & Poor’s 500 index includes large companies that cover about 80% of the U.S. stock market. Trailing earnings of the S&P are $68.72 a share. So when the S&P index recently hit 1,150, the P/E multiple was 16.73 (1,150 divided by $68.72).

Also, analysts have forecast annual earnings growth for the S&P, which theoretically would lead to price growth for the index. According to Bloomberg financial service, estimated earnings for the S&P for 2010 are $81.02, with projections of $95.56 in 2011 and 108.95 in 2012.

Using those estimates and the current P/E ratio, the S&P should rise to 1,356 this year with increases of another 18% in 2011 and 14% more in 2012.

The Fed model

The inverse of the Price/Earnings ratio is known as the earnings yield, which you reach either by dividing earnings per share by the price or by dividing the P/E into 1.

A valuation theory known as the Fed model uses the earnings yield to compare the relative returns on stock and bonds. It suggests that the broader stock market is fairly priced when the earnings yield on the S&P is about the same as the yield on the 10-year Treasury bond. When the S&P earnings yield exceeds the Treasury yield, the model considers the market to be undervalued, and when the S&P yield is lower than the Treasury yield, the market is overpriced.

Lately, the 10-year Treasury has been hovering around yields of 3.5%. The earnings yield of the S&P 500 – that is, earnings of $68.72 divided by a price of 1,150 (or 1 divided by the P/E ratio of 16.73) – is 6%.

Based on the Fed model, stocks as represented by the S&P are undervalued because the earnings yield of 6% exceeds the Treasury yield of 3.5%.

A couple of historical examples help illustrate how the Fed model has worked:

  • At the recent market bottom of March 9, 2009, the 10-year Treasury yielded less than 3% and the S&P’s P/E was 13.7, thus yielding 7.3%. Stocks were very inexpensive, based on the model, and subsequently rallied.
  • On Oct. 9, 2002, the 10-year yielded 3.6% while the S&P’s P/E was 17.6, yielding 5.7% – again inexpensive using the Fed model. Again, a rally ensued.
  • On March 24, 2000 the S&P had a P/E of 29.6 and a yield of 3.4%.  The 10-year Treasury was yielding 6.2%. Stocks began a two and a half year plunge.

Considering P/E ratios, earnings estimates and the Fed model are ways to put a “rational” valuation on the market.

But, of course, the market has a mind of its own. There are many variables that affect the prices of individual stocks and the markets on any given day. Domestic and global political news, for instance, can overshadow and obscure solid market fundamentals.

Valuation tools give us some perspective in determining where stock prices should be going. Rather than using these tools to seek “buy” or “sell” signals, the prudent investor employs them as guides to reinforce the appropriateness of equity positions in a balanced and diversified portfolio.

This is in sharp contrast to simply looking at the market’s meanderings on a stand-alone basis, which only tells us where we have been.

Arthur S. Rothschild, J.D., CPA, CFP, is a vice president at Landaas & Company.

Joel Dresang is vice president of communications for Landaas & Company.

initially posted May 17, 2010

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