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Equity Valuation Analysis August 2009

Equity Valuation Analysis August 2009

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Published by Denis Ouellet

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Published by: Denis Ouellet on Aug 25, 2009
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On March 7, 2009 I published S&P 500 VALUATION ANALYSIS: NEAR BOTTOM with the S&P 500 Index at 676, re-introducing the Rule of 20 PE as the most appropriate way to value equity markets because it factors the all-important inflation environment into the valuation process. On March 16, I published S&P 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS which thoroughly explained the appropriateness of the Rule of 20 as a valuation tool. I concluded that we were then at the trough with a low probability of making new lows in the 500-600 range for the S&P 500 Index. In fact, the Rule of 20 indicated that fair market values should be in the 791-923 range given then trailing earnings. In May, I published EQUITIES: TIME FOR A PAUSE when the S&P 500 Index was around 950. I concluded that The combination of declining earnings in a surging market has brought the “Rule of 20” multiple from 16 to 21.1, slightly above its historical median of 20 (range of 15 to 25). As a result, the risk/reward ratio has moved from extremely positive (16/20) to somewhat negative (21/20). Using earnings estimates as opposed to trailing earnings, one could justify buying equities at current levels, given that estimates for 2009 are about $60. On that basis, the S&P 500 Index trades at a “Rule of 20” multiple of 15 (as is the absolute PE since the current inflation rate is about zero). Investors who have faith in such estimates and who expect inflation to remain near zero could keep buying stocks. The case in favor of using estimates at present is supported by the fact that current trailing earnings include the exceptional Q4 2008 S&P 500 Index EPS of $-0.09. So far in Q1 2009, earnings are already running at a $51 annualized rate. The S&P 500 Index subsequently corrected 8.5% to 869, only to strongly recover to its current level of 1026 as accumulating economic green shoots and upward earnings revisions boosted investors confidence and scared cash-rich institutional investors.

Not that earnings have shown anything really positive, other than beating analysts’ low balled estimates. Trailing eps are $40, down 40% yoy, but these include the dreadful Q408 ($-0.09).Q2 eps came in at $14.00 for the S&P 500 Index, down 18% yoy but up 38% qoq. Using current bottom-up estimates, 12 months trailing eps will reach $54 in Q409. Earnings estimates have stopped declining and annualized quarterly estimates are now $64 for Q409.

Importantly, yoy earnings revisions have turned positive. Even top down estimates from normally more conservative strategists are rising: 2009 estimates are now in the $50-55 range while 2010 estimates are around $75, roughly in line with bottom up estimates, a rather rare occurrence given analysts’ legendary optimism. But that is the way markets go: equity prices generally turn before profits do:

WHAT ABOUT VALUATIONS? The chart below shows the conventional PE ratio for the S&P 500 Index using trailing earnings. As a general rule, patient and disciplined investors should play the odds using deviations of the PE from its “15 fair value”: in effect, investors should gradually accumulate stocks as the PE gets below 15, being fully invested around 10, and gradually disinvest as it gets over 15, being out of stocks around 20x. Using this 10-15-20 conventional PE range has not been optimal when inflation was very high (such as during the 1940’s and late 1970’s) or very low or negative (such as the 1930’s and in 2009). (See S&P 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS for a detailed explanation). At the recent market lows, which turned out to be a major buying opportunity, the conventional PE analysis kept many investors on the sidelines as the S&P 500 Index was selling at 15.6x trailing EPS, a level which only reflected fair value on that measure.

The Rule of 20 approach incorporates the inflation rate (and thus interest rates) into the valuation equation. It states that fair PE is 20 minus inflation. As the charts below show, themultiple historically fluctuates around 20 within a range between 15 and 25. As a general rule, patient and disciplined investors should play the odds using deviations of themultiple from its “20 fair value”: gradually accumulate stocks as the multiple gets below 20, being fully invested around 15, and gradually disinvest as it gets over 20, being out of stocks near 25x. Last March, when fear was rampant, the Rule of 20 gave the appropriate buy signal as the multiple declined below 15. Today, the ratio is over 26 as optimism has suddenly resuscitated.

WHAT ABOUT EARNINGS? The above analysis deals with facts, i.e. it uses actual 12-month trailing earnings of $40 at the end of Q209. For those who prefer the comfort of trailing earnings, the market is overvalued at a Rule of 20 multiple of 26 and a conventional PE of similar magnitude. But we must remember that current trailing eps incorporate 9 cents of losses recorded in Q408 when the economy was sinking and huge financial institutions were drowning. I dealt with these HUGE losses in S&P 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS but just to remind readers: As the fourth-quarter earnings season draws to a close, there are an estimated 80 companies in the S&P 500 with 2008 losses totaling about $240 billion. Under S&P's methodology, these firms are subtracting more than $27 per share from index earnings although they represent only 6.4% of weight in the index.(Jeremy Siegel) At the extreme, and we are admittedly in an extreme period, a large company with a tiny market capitalization could incur losses so large as to wipe out most of the S&P 500 earnings (AIG lost over $60 billion last quarter alone). As a result, the Index PE would skyrocket even though the other 499 stocks’ valuation would actually not change at all. In effect, a casual or superficial observer looking at the Index would conclude that equities are expensive or overvalued when, in fact, 499 stocks would be cheap or undervalued. With the release of its Q4 2008 results, AIG subtracted $5.13 to S&P 500 Index operating earnings and $7.10 to reported earnings in the December quarter. These losses will negatively impact the S&P 500 Index earnings throughout 2009. Yet, AIG is 0.02% of the S&P 500 Index so its market value has literally no meaning to the overall Index. Were the US government to completely nationalize AIG tomorrow, its removal from the Index would make no difference to the Index value but the removal of its losses, operating and reported, would immediately boost Index earnings by 7.8% for operating and 17% for reported. As we know, AIG was nationalized and Is no longer part of the Index, although its losses will continue to negatively impact trailing earnings until Q409 results are released in the first quarter of 2010. As other companies and banks get acquired, their negative impact on index profits disappear in subsequent quarters but keep impacting trailing results for 12 months. This is why trailing eps can be deceptive at certain times. The other important fact is that Q2 earnings came in at $14 or $56 annualized, up 38% from Q1. Interestingly, if one uses $50 eps (a 10% discount on Q2 actuals), the current Rule of 20 multiple becomes 20 at zero inflation, which represents mid-range or fair value. Such estimate is bang on with current bottom-up and top-down estimates. Not cheap enough to be aggressive but not expensive to the point of selling out. Actually, a pretty dull valuation reading, being right on the fence.

Going one big step further, annualized Q3 and Q4 estimates are $60 and $64. If you are willing to bet on estimates, the Rule of 20 multiple drops to 17 using Q3 and 16 using Q4 estimates, still assuming zero inflation. If current estimates prove accurate, equity markets have room to advance 17-25%, to 11201280, before they reflect fair value on these numbers. Should we bet on these estimates? The pros would say that the recession is over, manufacturers are entering an inventory restocking cycle, cost inflation is negligible, the housing market is showing positive signs and banks are enjoying fat spreads without having to mark-to-market. Earnings will be rising for a while. The cons will argue that the recovery is merely statistical, that the fundamentals remain weak and very fragile, that the consumer is worn out and that banks need to raise zillions in capital to stay afloat in the coming U, L, N or W shape recovery. And if this not enough, deflation is at our doors. For my part, recognizing validity in both sets of arguments, I nevertheless note that: • • corporate revenues remain extremely weak and only sharp costs cutting has enabled companies to show decent profits. In Q2, S&P 500 sales were down 24.8% yo and S&P Industrials sales were down 25.4%. Such profits are not resting on solid enough ground to attract very high multiples. Profit growth on weak revenues is not really attractive for my own taste.Here is how Standard & Poors commented on Q2 revenues for the S&P 500 companies:
Sales deteriorated significantly during the quarter, with margins helped by higher productivity. S&P 500 sales for the quarter posted their third consecutive double-digit yoy decline, with the 12-month decline also in the double-digit range, at –13.2%.

The US consumer, the ultimate engine for the US economy, is suffering immensely from this crisis: record high unemployment, decimated housing values, huge debt levels, low savings and prospects for higher taxes in coming years combine with rising food and oil prices to result in a major current and prospective squeeze on real disposable income. The risk to the US economy remains high; growth could be very subdued and profit margins would eventually collapse under continuously weak sales. Deflation remains a real danger.

In all, I personally wish to err on the safer side of things and discount analysts’ and strategists’ forecast in the current environment, until there is more evidence that the economy is back on more solid footings. Unlike last March, the Rule of 20 is not in bargain area and fear is not dominant. If consumers stay quiet during the all-important second half, world economies are likely to experience a double dip in early 2010. Finally, the deflation risk should not be forgotten (see below). On the other hand, US equity markets are not as expensive as they look on the surface and central banks and governments around the world are pumping liquidity like if there were no tomorrow (literally) . As I

said, if the consensus is about right, equities have good room to advance . This is not a time to be an extremist investor. WHAT ABOUT DEFLATION? Most people agree that inflation is not a threat for another 12-18 months given the enormous amount of slack in the world economy. Central banks’ money printing activities and rising government deficits OECD- wide could eventually bring inflationary pressures but not over the immediate investment horizon. Deflation risk is more significant over the shorter term as evidenced by recent CPI and PPI stats around the world (see my Inflation-Deflation posts).If the US consumer decides to substantially deleverage, Nouriel Roubini will prove too optimistic… Deflation would hurt equity markets significantly. First, corporate profits would be negatively impacted as revenues would decline faster than cost, like happened in the 1930’s. Second, PE multiples would suffer as investors would lose confidence in governments’ ability to cure the problem. Deflation is much difficult to correct than inflation or recessions. Denis Ouellet August 25, 2009 News-to-use.com

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