S&P 500 Fair Value: What to Expect in 2011

About two years ago I posted my mathematical assessment of the market's fair value. It's still a widely-referenced article. Given your interest and my own curiosity as I prepare my investment route for 2011, I thought I'd repeat that study using more recent data.

But this time, I'll use both a dividend discount model and an earnings growth model.

S&P 500 Fair Value from a Dividend Perspective

Using the Dividend Discount Model here's a quick summary of the market today and what is in store for 2011, if history helps.

If we treat a stock as a bond and nothing else, we're expecting to get in the future our model for dividends  that we got in the past, plus some growth. This is one of the most conservative ways I know to value a stock and hence why I'm using it here to value the index.

Here are the numbers:

1. All-Time Dividend Growth. Since 1960, the S&P 500 has grown dividends an average of 5.04% per year (note: variance is large, meaning some years this number is much higher, others much lower).
2. 10-Year Dividend Growth. The last 10 years have seen a lower dividend growth, just 3.58% annually.
3. Today's Fair Value. Assuming a 5% growth ad infinitum a 7.5% discount rate based on an estimated dividend for 2011 of $24.28, today's fair value is 971, meaning the market is overvalued by 33%.

Modeled value vs. real value for S&P 500 using DDM.

S&P 500 Fair Value from an Earnings Perspective

Earnings provide another way to assess the fair value of an index. By looking at historical growth and current earning yield, we can put a fair price on the index. However, earnings are a secondary measure of what one can get out of an index, since not all earnings flow to the investor as dividends. 

While earnings can give us a good feel for how the market is doing, it can't tell us what the companies will do with their earnings nor how they will return them to us investors. Dividends can be cut, but earnings are flakier, given that they're not usually thought as belonging to shareholders, which is a shame, but quite true of most companies.

Here are the numbers:

1. All-Time Earnings Growth. Since 1960, S&P 500 earnings have grown an annualized 6.81%.
2. 10-Year Earnings Growth. For the trailing 10 years, earnings have grown 4.07%.
3. Today's Fair Value. Assuming 2011 earnings of 87.84 and applying a P/E multiple of 15, the S&P would be valued at 1318 today, meaning the market is undervalued by 1.7%.

Modeled value vs real value for S&P 500 using earnings.

Conclusion

Whether you choose to believe the DDM is more accurate or the earnings approach is more accurate, both currently indicate that the S&P is anywhere from fairly-valued all to the way to grossly overvalued.

However, this numerical assessment assumes a smooth continuation of history without taking into account all that is going on with the economy, international affairs and expectations of inflation/deflation.  Use this to help you make informed decisions, but do not rely entirely on it.

The source of raw data is still here (no affiliation with the authors or their institutions).

Disclosures: I own SPY and many other whole market-tracking indices at the time of writing.

Preparing a Shopping List for Bad Times Ahead

Several pundits online and on mainstream media are calling for another "leg down" or plain depression in the markets soon.

I don't react to predictions, forecasts, star readers or fortune tellers. I will see when it happens. However, it's always good to be prepared for anything -- up markets, down markets, neutral markets -- at all times. As such, I have my shopping list ready in case the forecasters turn out to be right.

Because it's a long shopping list and it's mostly still far from my entry prices, I will just pick those that have been approaching my entry price recently. Many of these are names I already own and am looking to buy more of. Some are new.

Shopping list for the next "leg down"

PAYX (Paychex) - Buy range: $25-21, Current: $25.47
COP (ConocoPhillips) - $47-38, Current: $48.82
PFE (Pfizer) - $13-11, Current: $14.14
RDS.A (Shell) - $48-42, Current: $50.01
CINF (Cincinnati Financial) - $23-21, Current: $25.53
ETR (Entergy) - $75-60, Current: $70.70

Note 1: These are all dividend payers that have been around for a while and paying dividends for a while.

Note 2: Entry prices were based on my model of discounted dividend analysis and a qualitative assessment of earning power. The entry prices typically entail a total return from dividend plus dividend appreciation to 11 to 12%. Any share price growth is extra icing on the cake (and was not factored in the price).

Note 3: There are two oil companies on the list. This is a good thing, because when governments in developed countries start to print money seriously, oil, gas and tanker and pipeline companies will benefit. It's best to own the companies behind these commodities than own the commodities outright for various reasons that are beyond this article's point right now.

Note 4: I started buying Shell a little ahead of my entry price and am looking into buying more significantly when it does enter the buy range.

Note 5: I haven't bought Entergy yet because I haven't had time to investigate their price drop and read their latest 10Qs. As soon as I find out they're still in as good a shape as when I first priced my buy range, I will pull the trigger.

Disclosures: I own shares of PAYX and RDS.A at the time of writing.

Dividend Discount Model in Action -- LLY Stock Analysis

Recently, I noticed a stock on my watch list that hasn't returned to its pre-financial-crisis level: Pharmaceutical company Eli Lilly (LLY). Here's my analysis.

For a mature dividend aristocrat such as LLY, the dividend discount model is usually a good start in valuing the stock.

LLY has raised its dividend for over 25 years. Over the last 10 years, LLY has raised its dividend a compound 7.86%. Year-over-year, the minimum raise has been 4%, the maximum 13% and the average raise was close to 8%.

Meanwhile, earnings per share (EPS) growth has only compounded by 1.65%. So the growth in dividend is probably not sustainable without further improvements to the bottom line, such as cost cutting or acquisitions.

If we assume a 1% growth in dividends (to match the growth in EPS) in perpetuity, and tag it with a 9% discount (my minimum expected return from solid stocks), the dividend growth model yields a price of $25.

LLY currently trades at around $34, has a forward P/E of 7.8 due to analysts-expected EPS of about $4.25 for 2009.

LLY's 10-year average EPS is only $2.00, though. The growth expected this year and next is attributed to a strong drug demand, the acquisition of ImClone and cost cutting. The company's own EPS guidance for 2009 suggests EPS between $4.20 and 4.30. It's unclear how sustainable this new EPS level is.

Historically, LLY P/E ratio has been quite high: the average low P/E was around 22 while the average high P/E was 34. Counting on market euphoria to bring the P/E back to its historical lofty levels is never a good idea. My comfort range of P/E for a large and mature company such as LLY is between 10 and 15. Using LLY's average 10-year earnings of $2.00, we get a price tag of between $20 and $24.

Looking at dividend and EPS growth and checking the P/E ratio is only part of the analysis. I said earlier that it's usually a good start because mature companies such as LLY often have stable earnings, growth, debt load and share count. But a further look at the balance sheet is always helpful. Consider the trends in the graph below.



Looking at various balance sheet indicators as a percentage of sales can help spot worrisome trends. In this case, it's encouraging to see that both research and development (R&D) and accounts receivable have been moving inline with sales. Inventory had a run up in the past that warrants further investigation, but doesn't appear to be out of control. Selling, general and administrative expenses (SG&A) have been growing slightly faster than sales, which might indicate that LLY is not as efficient as it used to be 10 years ago. Nonetheless, the trend is not sky-rocketing either.

Overall, these trends are somewhat reassuring that the dividend discount model is meaningful as it shows the fundamentals are not quickly deteriorating.

Conclusion: from a purely dividend discount valuation and a check against a conservative P/E multiple and a conservative EPS estimate, my initial fair value for a share of LLY is between $20 and $25. Further investigation into drugs in the pipeline, patent expiration and integration of acquisitions is necessary to further determine earnings power and hence fair value.

Disclosures: No shares of LLY held at the time of writing.

Alternative valuation methods are harmful to one's pocket

Ben Graham taught us to look for discounts to net current asset value in order to protect against large declines in stock prices. Net current assets are current assets (cash and equivalents) minus current liabilities (all debts to be paid within a year).

But despite this method being proven to provide good results with minimal downside, people still choose to dream up their own convoluted valuation methods for investment.

Consider for example the use of the "eyeballs" metric at the peak of the dot-com bubble. Firms with no income were being appraised based on the number of people visiting these companies' web sites. That can barely show potential for future revenue, and it says nothing about real earning power nor what matters, profit-making.

While "eyeballs" seems ridiculous in hindsight, it wasn't questioned by many back then.

Other unproven valuation metrics are created all the time. Consider for example "economic goodwill". It states that the difference between market capitalization (share price times number of shares outstanding) and net tangible book value is the amount of "additional value that the market has assigned to a company, based on intangible assets, such as quality of management, growth prospects and efficiency of operations, that don't appear on a balance sheet".

The theory was that the lower this amount compared to the average of return on assets, return on equity, debt-to-equity ratio, and percentage growth of earnings divided by percentage growth of revenue, the cheaper a company would be.

This one study from 2000 thus picked the 10 most undervalued companies back then based on this metric, as shown below. The number in parenthesis is the return on their market price from 2000 until now.

American Power Conversion (-100% -- delisted)
Computer Associates (-74%)
Intel (-77%)
Microsoft (-58%)
Pomeroy (-81%)
Symantec (+63%)
Tellabs (-92%)
Verisign (-92%)
Viant (-100% -- delisted)
Xilinx (-78%)

To be sure, no valuation shortcut is infallible. Ben Graham never said the net current assets method can prevent loss. It can't, since the future is and will always be unknown. But if anything, it provides the best protection one can get short of clairvoyance.

People should be happy to buy dollar bills for fifty cents. Anything else is speculation.