Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Playing the Valuation Game


Analysis suggests earnings are on their way up.

After several months of glorious advances, stocks have stagnated of late. Trading in a largely narrow range, stocks appear to be searching for a reason to move. Some expect them to advance, while others anticipate, at best, a long-overdue (meaningful) correction, or, at worst, a test of the lows we saw last November and in early March of this year. Both camps can find plenty to support their points of view.

The bears point to surging oil prices (see USO), surging US Treasury rates, fears of future inflation, a weak US dollar, fears of US socialism (i.e., health care), a mountain of government debt, fears of regulatory overkill, government intrusion in the market (of which payouts to banks like Wells Fargo (WFC), Citigroup (C), and Bank of America (BAC) -- as well as buyouts of GM (GRM) and Chrysler -- are just some examples), and so on. The list is long. On the other hand, the bulls point to more normalized yield spreads, signs of economic stabilization, and the normal digestive process of strong market action over a relatively brief period as an explanation for the stagnation of stocks.

Yet, as interesting and beneficial as such a debate may be, this talk places the what-I-believe cart in front of the what-is horse. The "horse," in this case, is valuation.

What makes valuation analysis so useful is that it incorporates the key elements of economy and markets --earnings, growth of earnings, and risk -- while, at the same time, placing in context the real and financial economy issues note above (and others). Perhaps more importantly, what valuation analysis is beneficial to the investor in the same way that technical analysis is: it provides the investor with the message of the market, thereby enabling them to decide whether the message makes sense.

Allow me to illustrate:

At current levels, the S&P 500 is trading at approximately 21 times trailing the trailing year's operating earnings (940 divided by $44). The bears howl that this is evidence of a severely overvalued market. After all, 21 is well above the average of 15 for large-cap stocks. While this backward-looking, what-should-have-been exercise has some value in itself, it distracts you from looking forward to expected returns and P/E.

Here's what I mean:

Taking the above fact that the average P/E for large-cap stocks is 15, the message of the market appears to be the following:

  • 940 (current S&P 500 level) x 12% = 1052

  • 1052 divided by 15 = $70 operating earnings

I'm using 12% as the historical return for large-cap stocks but, if you wish, you can use 10%, the lower expected/required return/cost of equity. It's the forward-looking process which conveys the message of the market that matters
< Previous
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Featured Videos