It's a fact of investing life that when a long bull market ends, people fear for their livelihood and investors dissolve into a puddle of anxiety. People run to the exits, indiscriminately selling stocks at any price they can get.
What people tend to forget at this time is that most of the value of a common stock comes not from earnings this year but from the future earnings this business will generate in the years to come. In the case of strong businesses, one or even two years of earnings decline don't necessarily matter in the grand scheme of things.
In my view, the intrinsic value of a stock can be derived from the discounted future cash flow (or earnings) going far into the future. Even if the earnings per share of a share of common stock are impaired for a year or two, it does not matter that much to its intrinsic value. Here is my personal take on this valuation method.
Discounted cash flow
Imagine that the S&P 500 is a single stock. Its price is ~$2,789 as I write, and this stock earned $133.70 a year in net earnings in 2019. Assume now with the Covid-19 pandemic, it will only earn $100 this year (a fall of 30%), and next year it will earn $90 (a further fall of 10%). Note that even the more bearish analysts are not predicting things to be this dire; as of the end of March 2020, analysts surveyed by Factset are only predicting a decline of 7.5% for the year.
In 2022, I predict that the virus will be behind us and annual earnings of $133.70 will come back. Thereafter, I factor in earnings grow at a sedate pace of 5% a year for 10 years, a huge cut from the S&P 500's overall per annum growth rate.
At the 10-year point, let us assume that the S&P 500 will be selling at a price-earnings ratio of 15 (which is the long term average - right now it's about 16). We then take the net present value of the cash flow for 10 years as well as the capitalized value of the S&P 500 ten years from now and calculate the net present value of the S&P 500. I am assuming a discount rate of 3% (which is four multiplied by the 10-year treasury yield).
Once I plug the above figures in a spreadsheet model, I get a hypothetical S&P 500 stock valuation of $3,344, with a margin of safety of 26% (embedded below).
Therefore, even if you assume a 30% earning reduction of the S&P 500 this year and then another 10% drop next year, with what are in my opinion very conservative assumptions, the S&P 500 is undervalued by around 25%.
Sure, Mr. Market could have another serious setback and race back down for a while, re-test the lows and even break lower, but that's no reason to sell anything good out of your portfolio. Trillions worth of government stimulus for businesses together with massive decline in interest rates are incredibly powerful when working together.
I expect a deep but short recession. The second quarter will likely be pretty bad, and perhaps the third as well. By Q4, I expect economic recovery will be gaining full speed. Many businesses will not survive, but others will take their place. Life will go on. According to legendary investor Sir John Templeton, “The four most dangerous words in investing are, it’s different this time.” It's not different this time. A stock is worth the discounted sum of its long-term cash flows in perpetuity, the small minority of cash flows that come in the next few quarters should be largely irrelevant. In other words, the long-term earnings power of a stock is measured more by long-term averages than earnings at the bottom of a recession.
Disclosure: I/we have no positions in any stocks mentioned.
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