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Do Low Multiples Mean the Market is Undervalued?

April 07, 2008
10qk

Turley Muller

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S&P 500 is trading at low price multiple to expected earnings, 13.7 according to WSJ. The historical forward P/E has been in the range of 14-16, depending on how far you look back. With interest rates incredibly low, 3.88% on the 10-year, should make the fair-value multiple even higher.

According to my calculations, the S&P 500’s mean P/E = 14.2 and median = 13.2. Thirteen companies were excluded due to negative earnings. The highest P/E was 90, and only ten firms had multiples greater than 30. The chart shows the frequency distribution of the individual firm’s P/Es constituting the index.

So is the market cheap? The low price multiples suggest that it is.

SP-stocks-PE.jpg

The Consensus estimates point to a strong recovery. According to Thompson, Analysts predict earnings to jump 15.3 percent this year.

In my opinion, that magnitude of growth is wildly optimistic. The Market isn’t buying it either. It’s not that the market is cheap, it’s that investors believe consensus estimates are too high. Why do I think that? Because if the market had full confidence in the forecasted numbers, I doubt the market would trade at these multiples. Hence, investors are pricing in lower earnings than the consensus forecasts thus making multiples higher.

The most probable outcome will be downward revisions to the earnings estimates. It’s possible that some of the consensus numbers are stale, meaning analysts have been slow to update them. This seems plausible given the current environment of uncertainty, and the inherent lack of visibility, may delay updates to estimates. In some cases, analysts may be waiting for a clearer picture going forward, or updated guidance from firms before making revisions to this and next years’ full year estimates.

Another possibly is that the required rate of return investors demand from equities rose, the “Equity Risk Premium.” This implies that the Market perceives increased risk inherent in the equity markets. This seems plausible since volatility has increased relative to years past. Higher perceived risk leads to higher demanded returns which compresses price-earnings multiples.

In my opinion, stocks are not as cheap as forward multiples suggest. Earnings estimates are too high and are likely to come down. In addition, the ERP has increased pinching multiples. However, if the economic slowdown begins to appear less severe as the Market is expecting, then stocks would be rather cheap. That would mean that analysts are not overestimating future earnings. However, given the turmoil in the housing market and the relationship to consumer spending, it’s likely the coming quarters will be weak.

SP-stocks-PE-dist-graph.jpg

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Source: Financial Alchemist

About the author:

Turley Muller
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.9/5 (11 votes)

Comments

gav_sharma
Gav_sharma - 6 years ago
Analysts will keep predicting bright future and higher earnings until the CEO of the company himself comes on conference call and says we cant make the returns this year........they will keep pushing the stock up until all the insiders sell at higher prices and common man ends up being a sucker.

http://www.bloomberg.com/apps/news?pid=20601109&sid=aafbjqdWG7pQ&refer=home
Dr. Paul Price
Dr. Paul Price premium member - 6 years ago
Other than saying you don't believe the analyst estimates you really didn't offer any conclusion as to whether you think 'the market' is a buy or not.

batbeer2
Batbeer2 premium member - 6 years ago
Stockdocx, congratulations with your win !

P/E's are a little low in historical terms. Thats for sure. Wether you feel analysts are optimistic or pessimistic does not change the numbers. This may also have been the case at other times when P/E was low.

The fact that you feel the estimates are high says a bit about the analysts and a lot about your own analysis of the situation.

Now for the good news... You don't have to buy all of the S&P 500. You just buy those you feel comfortable with. Sometimes a stock is a steal at p/e of 25 sometimes the same stock is overpriced at p/e of 4. This may also be true of the S&P at this point in time. Time will tell.

Just remember that for everyone that thiks it's a steal there is at least 1 other person glad to be rid of it at that price. Then again 60% of investors never reads an annual report so it shouldn't be hard to know more than the other guy.
crafool
Crafool - 6 years ago
Low multiples are definitely a starting point, but not the end all be all. You should also consider the amount of long-term debt a company or in this situation the S&P 500 is using (Sometimes a lot of debt per share can obscure the valuation look at Hershey (slight over value in my opinion) or Barnes and Noble with no long term debt (good value in my opinion). Then, yes we have to look at earnings. Analysts are frequently wrong, however even revisions to earnings are rarely off by 50%. Finally, we have to look at the risk free rate of return (I use the 10-year Treasury bond), and add your own individual risk premium to it to fully determine if stocks are attractive.

My own personal opinion based upon balance sheets (some of the best in years), current multiples, earnings revision (most likely no more than 20%) and an extremely low interest rate environment has me believing that the S&P 500 is fair to under-valued, however if you look at the Mega-Caps (GE, PG, KO, AXP, WFC) there could be some real good opportunities. I believe these companies could actually support those bubble multiples investors put on them in the late nineties given the current interest rate environment (3.59% (now) versus 6.5% (then)) I would venture to say that in some areas best buys you have seen in a very LLLOOONNNGGGG TTTTIIIIMMMEEE.

Stay away from small and mids, and lower that international exposure.

Best to all, and happy investing.
turley.muller
Turley.muller - 6 years ago
This article I wrote back in February,

http://financial-alchemist.blogspot.com/2008/02/do-low-multiples-mean-market-is.html

The latest article is [financial-alchemist.blogspot.com]

I think that is was Guru Focus may have intended to post.

Responding to the 2nd comment- "you really didn't offer any conclusion as to whether you think 'the market' is a buy or not."

I don't usually look at stocks as a whole, rather evaluate on a one by one basis, so some stocks are cheap, some are expensive, and some are priced about right. I was more or less, attempting to explain the low multiple and the possibility that it's because the market believes estimates are too high.

Read my recent article where I discuss revisions to those estimates.


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