The stock market is an endless tug-of-war between bulls and bears. Bulls are optimistic about the future and bears see problems. At the core of this battle is a disagreement about stock market valuation. More specifically, how much is a dollar’s worth of corporate earnings worth? This is Part 1 of a two-part article, and we will cover different valuation ratios. Part 2 will consider the importance of real earnings growth.
The fair value of any investment is its future cash flow discounted for risk. Future cash flow includes, but is not limited to, interest income, dividends, rent, royalties and its terminal value. Risk is the probability that some or all of these future cash flows will not materialize.
The terminal value of a company is the price at which a stock is taken off the market. A company may be privately acquired or merge with another company, or it may delist due to bankruptcy or liquidation. The first two scenarios may result in higher terminal values while the last two scenarios often result in a terminal value close to $0.
Dividends are a byproduct of business earnings, but not the only byproduct. A company may use their earned income for three basic purposes: investment, stock buyback and dividends. Each board of directors decides the best use of earnings after assessing the potential gains from investment and stock buyback programs. Accordingly, it is difficult to make the case, as some do, that dividend policy alone should be used as the market’s sole valuation indicator.
Price-to-earnings (P/E) is probably the most often used bellwether for stock market valuation. This ratio compares the current market price to its trailing 12-month reported earnings. For example, the S&P is currently priced at 1433 and trailing 12-month earnings are about $100 per share resulting in a 14 P/E today.
Unfortunately, the reported earnings used to calculate P/E can be deceptive at times. The figure isn’t a clean number, meaning it includes one-time adjustments due to tax law changes, new regulation, gains from asset sales, write-offs, and other non-business related events.
S&P provides an alternative to S&P 500 reported earnings that smooth this number. “Operating earnings” focus on business operations to provide a cleaner look at core enterprise profitability. Operating earnings may help us focus on what drives a company.
Unfortunately, operating earnings doesn’t help with valuation either during a recession because earnings become volatile at all levels. Corporate earnings hit a peak before a recession, fall during a recession, and recover after the recession. By definition, with no change in the price of stocks, a recession will cause both reported earnings and operating earnings to decrease, which causes P/E ratios to increase.
Some people say that any jump in P/E or price-to-operating earnings (P/OE) is an indication that the market may be overvalued and investors should consider selling. This view doesn’t hold water in a recession because earnings are relatively meaningless at that time. P/E and P/OE will fall back when the recession is over and earnings recover.
I believe the solution to the earnings problem during a recession is consider long-term earnings potential from U.S. companies rather than the past 12-month earnings. One technique is to look through recessionary earnings and value the market using price-to-peak operating earnings ratio (P/POE).
Peak operating earnings is either 12-month trailing operating earnings when they are at a high or the highest past 12-month trailing operating earnings when they are not. Figure 1 illustrates the difference between S&P 500 trailing 12-month operating earnings (red) and peak operating earnings (blue).
Figure 1: S&P 500 12-month Operating Earnings and Peak Operating Earnings
Figure 2 plots earnings data from Figure 1 against S&P 500 price over the same period. Trailing price-to-operating earnings (P/OE) represents the red line and price-to-peak operating earnings (P/POE) is the blue line. Falling earnings (rising P/PO) occurred during recessions and that’s when the red line is present. The 10-year Treasury yield is included for reference.
Figure 2: S&P 500 Earnings versus Price
The historic price-to-peak operating earnings (blue line) in Figure 2 is a smoother line than price-to-operating earnings (red line) because it gets eliminates P/OE spikes caused by recessionary earnings. The ratio also does a better job telling us where valuations are today relative to historic norms. P/POE today is at 14.4, which is lower than the 15 average over the time period.
The 10-year Treasury is also included in Figure 2 as a reference. In the long-term, lower trending interest rates tend to foster higher P/E ratios higher. That has not happened yet in this cycle, but I believe the probability is high that continued low interest rates will nudge stock prices up into higher multiples of earnings, assuming earnings continue to grow at a modest rate.
Click here for Part 2 of this article. I’ll explain were earnings growth originates and how a small positive (negative) change in the earnings growth forecast can push stock valuations higher (lower).