Why Fair Value For The S&P 500 Is Not 440

Barry Ritholtz, market veteran and blogger over at The Big Picture postulated today that fair value for the S&P 500 might be 440. He got there by taking trailing 12 month GAAP earnings of $28.75 and applying a 15 P/E ratio to them.

Personally, I expect more from Barry given how strong much of his market and economic analysis has been over the years, but there are glaring flaws in this valuation methodology. First, I don’t know very many market strategists who believe fair value on the S&P 500 should be based on the earnings produced by the index’s components in the depths of a deep recession. Most people agree that fair value should be based on an estimate of normalized earnings, not trough (or near-trough) profit levels.

Imagine you owned a Burlington Coat Factory retail store. You are ready to retire and have a business person interested in buying your store. What would your reaction be if this person took your store’s profit for the month of June, multiplied it by 12, and based his offer price on that level of projected annual profits. Clearly that figure does not give an accurate representation of how much money your store earns in a year because June is probably one of your worst months of the year for selling coats!

The same flaw exists in valuing the stock market based on current earnings. Doing so implies that earnings today represent a typical economic climate, which is clearly not the case.

The second issue with Barry’s analysis is the use of “as-reported” GAAP earnings. The reason GAAP earnings have fallen so fast is that they include non-cash charges such as asset impairments. It is common these days for companies to report cash earnings of $1 billion but a GAAP loss of $5 billion due to a $6 billion asset impairment charge. In such a case GAAP earnings (which include the non-cash charge) are understated by a whopping $6 billion. Why should asset impairments be excluded? A stock’s value is based on the present value of future free cash flow. Since cash flow is what matters to investors when valuing the market and specific stocks, non-cash accounting adjustments (such as asset impairments) don’t really play a role in fair value estimations.

The interesting thing is that you don’t have to take my word for it on this topic if you don’t want to. The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings (S&P 500 at 834 divided by 28.75) is excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.

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12 Thoughts on “Why Fair Value For The S&P 500 Is Not 440

  1. Adamchik on February 13, 2009 at 12:00 PM said:

    “[U]sing GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.”

    Unless that is where the market goes ….

    Perhaps with the destruction of financial services earnings, the S&P will look much less attractive going forward, the more that people consider it. Maybe we are just in the slow painful process of reverting to historical norms, when valuations were much lower:


    This is probably not an average recession, but a rare system-wide redirection. I am not sure how to account for that in most any model.

  2. Coming up with a “fair value” of anything is an absolute waste of time. The only thing relevant is what the last price was, what you’re willing to pay and what someone is willing to accept. Arguing about “fair value” is like arguing about how many angels fit on the head of a pin.

  3. Chad, All your crappy valuations made google at 50x earnings look like a good buy. Now you want us to believe the same valuations that RATIONALISED the outrageous prices of the bubble should now be used to argue for fair value, or better-than-fair value?

    Give me a break.

    The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings IS NOT AT ALL excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value.

    WHAT IT IS evidence of is that youre valuation method is flawed. The complete idiots who were saying BUY in august 07 look completely foolish saying BUY now. You were wrong then, why is it suddenly different now? huh?

    Do the analysts have a “Buy more” rating?
    How about a “This time I mean it” rating.

    Its over. Move on. The valuations were worth as much as the garbage the banks burned themselves on.

    What they should have been saying is “Bye” not “BUY”.

  4. Pingback: Business & Finance Blogs » Blog Archive » Friday links: collapsing earnings

  5. In order to make any logical plans for the future, one needs to build a model that explains/predicts it and hope this model is good.

    Chad’s arguments stand on the belief that this is not a drastic market- and life- changing recession.

    If this is correct, I’d be curious to hear if he is ready to question/test that presumption and how.

    I suspect he might not be. At some point, the what-if scenarios become so complex it is easier to solve them by utilizing a living and investing philosophy rather than analytical thinking.

    You see drastic events only so often and they are drastic because nobody knew in advance when were they coming and how were they going to shape up the future.

    One can spend their life preparing for such an event and may be even more or less successful in doing so. Personally, I think it would be a wasted life, but that’s because of who I am. A different personality may be just built for the task.

    I’d rather focus on the much longer and more predicable periods between such events. I accept the existance of major crisis, but limit my preparations to believing that whenever they come my best chances are in being ready to take hits, doing my best and holding on to believing I’ll get through.

    The different philosophical view points is what differentiates Chad’s and Bill’s interpretation on the quoted statistic.

    I like Chad’s one better because it gives me something to hold on to.

    But, again, it is a matter of choice, not knowledge or logic.

  6. Hi Chad,

    That wasn’t an analysis, it was 2 sentences and a excerpt from the WSJ article. I assumed a brief post like that was pretty obviously only referencing the WSJ article, and not a full blown analysis (like say this post: .

    But there is a bigger issue worth addressing: What will S&P earnings be? What should a fair P/E multiple be? How far along is the mean reversion process?

    I have a few posts in the queue about earnings. I’ll try to get a real piece up this coming week . . .

  7. Interesting response. I added my two cents there, showing a long term PE ratio based on 10 years rolling earnings.

  8. Pingback: » Wartość godziwa indeksu S&P500: 435? Trystero: O tym siÄ™ nie pisze.

  9. Chad Brand on February 16, 2009 at 9:55 AM said:

    I guess there are two issues. How one should value the stock market and where this recession ranks with past ones. I’ll ignore the comment that implied I said GOOG was cheap at 50x earnings, because an examination of my GOOG views on this blog will not prove that to be an accurate assessment of what I said at the time.

    Regardless of whether we are in a bubble or a depression or something in between, how one values the stock market should not change. The emotional element often results in us making poor decisions in times of extreme, but the value of a stock is always going to be the present value of projected future cash flows.

    There are some people who think this recession truly is different and therefore previously used methods of measuring value in the market are outdated.

    Personally, I don’t agree. Even in the Great Depression, traditional valuation methodologies didn’t die. They survived that period and should survive this one as well.

    As for where this recession ranks, and will ultimately rank when it’s over, the numbers don’t suggest we are worse now than we were in either 1973-1974 or 1981-1982. Economic indicators such as GDP decline and unemployment have yet to even reach the levels they reached in those 2 prior recessions. Many are forecasting we will reach those levels, and we probably will, but even when that happens, it will only put us on par with the other 2 severe recessions our country has endured over the last 4 decades.

    Until the evidence shows some evidence of it, I cannot comfortably claim that “this time is different.”

  10. marc priest on February 16, 2009 at 11:13 AM said:

    Valuations are useless. If there are more buyers than sellers and price goes up, than the buyers by default are correct except for the last layer that pay the top. And of course the first ones in are considered to be genius, but likely they are the ones saying to buy more as they are putting up spoof bids to make it look good. This happens every day in the futures. EVERY DAY!!!!!!!! And when the bulls are done and have gotten out, the price falls. The last bulls in lose and the shorts who shorted low are also losers when they tap out at the top. Now the same can be said for the shorts who got in at the top but there is one difference. What mutual fund and what brokerage firms have you seen that consistently come out with SHORT recommendations? I can not think of many that actually say, this and the last time I recall a stock getting talked down was GOOG at around 450 or so in April 2008. I think the “talk down” was less pay per clicks or some nonsense.

    Then they gapped the stock and ran it to 600. So it was all designed to get shorts in who listen to CNBC.

    So Chadd, really, don’t be silly and think that valuations have any type of merit. It’s completely perceived and every day I have a software program that literally calculates where the upper and lower values are for the day. Otherwise known as distribution and 70% of all trades happen within the UPPER and LOWER value areas….so we sell above the Upper value area and buy at the lower value area. Todays shorts….over 7762 cover under 7733….

  11. are you the kind of model-er who led us into this crisis? I dont read enough of your post to say you are consistently wrong, but your defense of capital one shows the flaw of your model. IT DOES NOT STAND UP TO REAL WORLD CONDITIONS.

  12. DEBATE Valuation all you want. IT doesn’t matter if you agree with valuing the market with TTM GAAP based PE ratios or not. The proof is right there – if you just look at a chart showing historic market action in terms of TTM GAAP based PEs.
    In times like the post WW2 mkt, and early 30s etc, the market traded BELOW a PE of 10 based on GAAP eps TTM.

    So the chart of the markets action based on ANY version of PE ratio would look the same. (The only difference would be the number the PE is showing).. Understand?

    If when I have the market showing a PE of 12, while you have the market showing a PE 50, the chart would look exactly the same if you show a chart of the market overlapping a chart of what the high, low and “fair value” PEs would look like.

    Point being, you guys are arguing the wrong topic. You are really arguing what a PE should mean – not how low markets should go.

    We are in a new economy (compared to the last 30 years). We are looking at GLOBAL DELEVERAGING of funds, banks, corporations and governments around the world as opposed to the last 30 years of growth fueled by increased leverage, increased free trade etc.

    What you will see on top of that are higher commodity prices, higher taxes, corporations having a harder time profiting (higher corporate taxes) etc.

    So when the market considers the value of future cash flow discounted back, it has to consider that growth will be much more difficult to achieve.

    And that is why the PE should be low (no matter which way you calculate it). It is likely going to be low relative to history. Low like it was in the early – mid 40s and the early 30s. People will write books about this in 100 years.

    Play the downside and profit from it.

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