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Why Dow 3,931 is "Fair Value" Based on GAAP Earnings

Tuesday, February 17, 2009 | Chris Rowe

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Two weeks ago I wrote an article "Why Dow 6,586 is "Fair Value" (or very overvalued!)"  But that's only another 16% decline.  That can happen in a single day or week!

Today I'm here to tell you that the market can, and probably will, trade another 30% to 50% lower before the next bull market starts.  (NOT "BEAR MARKET RALLY", BUT "BULL MARKET").  As this happens, you can make huge profits by taking bearish positions.  But I want to make sure you TOTALLY GET what I was saying two weeks ago, because it might mean the difference between your account's boom or bust!

The valuation that I was discussing was based on what the market considers "fair value" to be - AS OF THE THIRD QUARTER OF 2008.  Based on some comments left on my article it seems this needs more explaining. 

The market valuations of Dow 6,586 and S&P 684 PE ratio (price to earnings ratio) of the trailing 12 months as of the third quarter of 2008.  

But after publishing the article, it occurred to me some of you may not be familiar with what that even means.  So if you DO know what that means, then please bear with me for 3 or 4 paragraphs.  (I promise this isn't an article about what PE is so, again, bear with me.)

If a company earns $1.00 per share and the price of the stock is $12.00 per share, then it's trading at 12 times earnings and it has a PE (price to earnings ratio) of 12.

If a company earns $1.00 per share and the price of the stock is $35 per share, then it's trading at 35 times earnings (with a PE of 35).

When a company earns $1.00 per share, how do we know what stock price is reasonable?  Well, there are a large number of things to consider, but at the most basic level, when investors think the company will grow their earnings faster, they are willing to pay a higher price.  Check out the example below where both companies earned $1.00/share.

Company (Stock) A

2004 earns 16 cents per share
2005 earns 20 cents per share  (25% growth)
2006 earns 30 cents per share  (50% growth)
2007 earns 50 cents per share  (67% growth)
2008 earns $1.00 per share  (100% growth)

Company (Stock) B

2004 earns 70 cents per share
2005 earns 78 cents per share  (11.5% growth)
2006 earns 87 cents per share  (11.5% growth)
2007 earns 93 cents per share  (7% growth)
2008 earns $1.00 per share  (7.5% growth)

Both companies earned $1.00 in 2008, but obviously company A is growing their earnings much faster.  So even though they both earned $1.00 per share, company A will probably have a much higher stock price (because investors are willing to assign company A a higher PE ratio).

Okay, so we got that out of the way.  Now I'm going to give you the very short version of what I'm saying about future market valuation ...

Corporate earnings are going down, as the global economy is in a recession (and may even slip into a depression).  So if earnings for the S&P 500 over the last 12 months are $46.00 per share and the S&P 500 closed Friday at 826, then based on GAAP earnings (calculated using Generally Accepted Accounting Principles) the S&P 500 has a PE ratio of 18 because $46 (GAAP earnings) x 18 (PE ratio) = 826 (S&P 500 current valuation).

Now ask yourself: Why would we allow the S&P 500 a PE ratio of 18?? 

When the S&P 500 has a PE ratio of 20 or more, it's considered overvalued, a PE ratio of 15 is considered fair value, and a PE ratio of 10 is considered undervalued.  But a low PE ratio is assigned to stocks when the earnings growth is expected to be low. 

Now ask yourself: Do we expect stellar earnings growth, low earnings growth or NEGATIVE earnings growth?

There are two things that can bring valuation of the stock market down (in this discussion):

1. Earnings decline.  The PE ratio I'm talking about is based on the GAAP earnings of the trailing 12 months ending in September 2008 (that's all the data we have so far, as we don't have complete fourth quarter earnings data yet). 

Let's say you think the current PE ratio of 18 is reasonable (which it's not) and S&P 500 trailing 12 months earnings are halved over the next 6 months.  That means S&P 500 earnings will be $23.00.  If the market trades at 18 times earnings (PE of 18), then the S&P 500 will be at 413 (a stock market decline of 50%). 

2. Lower expectations to a reasonable level.  Now, if earnings really do decline by 50%, then we aren't looking at stellar earnings growth, are we?  We aren't even looking a low earnings growth.  We are looking at a market that should probably be assigned a PE of 10 or 15.  

PE of 10 on $23 earnings = S&P 500 at 230 (another 72% decline)
PE of 15 on $23 earnings = S&P 500 at 345 (another 58% decline)

Even if earnings didn't decline, and we just saw zero growth for several years, the market should be assigned a very low PE ratio.  If earnings stayed at third quarter 2008 levels of $46.00 and the market had a PE ratio of 13, the S&P 500 would be at 598 (a 29% decline).

OUCH ... 

... for those who have no bearish positions.

Guess "what?"  Q4 earnings season is almost complete.  It looks like the S&P 500 will have a PE ratio in the 30s!  If one more person comes out and says America is on sale I will be forced to use profanities. 

Now maybe we get a nice pop in this stock market before that happens.  That is TOTALLY in the cards.  Anything can happen.  Maybe the market rallies 25% before that happens.  But if the market does rally, then start putting on your bearish positions.  Members of The Trend Rider are hedged and prepared. 

Are you?

I'd love to hear what you think.  Do you believe that a PE ratio of 18 is realistic for the S&P 500?  Are you at least hedged against the possibility of more declines ahead?  Please let me know your thoughts by commenting on this article below.



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“Profit from the Trend”

Chris Rowe
Chief Investment Officer
The Trend Rider


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30 Comments

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  1. CHUCK (1 year ago) Is this Spam?

    great article, from a teaching perspective it's a 10 on 10 point scale. Unfortunately i am not knowledgeable to know if you are right. But the concepts certainly make sense. you seem to be saying we are in for a lot more hurt and if we go in then inch in, take a quick profit and get out.

  2. Chris R (1 year ago) Is this Spam?

    Robert,

    They are likely either using pro-forma earnings or operating earnings. But that is a false way of looking at it. If you look at the article I wrote 2 weeks ago http://tycoonreport.tycoonresearch.com/articles/555119679/why-dow--is-fair-value-or-very-overvalued

    and you look at the chart, it's all based on GAAP earnings. That's the real earnings. But either way you slice it, the market is overvalued in terms of PE when you look at operating earnings (which should be about $$55 or $56 you see based on Q4 2008 we are at about 16 or 17 PE ratio. Do you think we should be trading with a PE suggesting we will grow earnings or one suggesting earnings will decline (as they have already and will continue).

    The earnings will continue to decline and as the earnings decline, that makes the PE higher. So even looking at the inflated way of looking at it (based on operating earnings) we are overvalued. But if you look at the chart I refer to, it's all based on GAAP. Look at what HISTORICALLY has happened. You will agree no matter which version you consider.

  3. Simon (1 year ago) Is this Spam?

    Great article Chris!!



    Another mentor i follow said something very interesting... he said "market sediment will kill you in trading, you must let the market dictate the direction you go. As soon as you form an opinion and act on just that... your bias will affect you from making the right decision's based on the indicators in front of you."



    good advice me thinks!

  4. Robert (1 year ago) Is this Spam?

    Great article Chris, but your S&P earnings numbers seem to be way lower than what Zacks is using. What do they have wrong?

    http://www.zacks.com/commentary/10062/Will+Q1+Be+Worse+Than+Q4%3F

  5. Richard (1 year ago) Is this Spam?

    I totally agree author's projection that the Dowjones low could locate between 4000 to 5000 points if US goverment does not present extraordinary policy.

    The hit of 4000 could cause the extraordinary policy generated.

    800 Billion bailout was a small piece of cookie to the present system defect.

  6. Barbara (1 year ago) Is this Spam?

    loved your article. It makes absolute sense. Keep up the good work. I wish I had the money to get your trend rider. Hopefully, with your intellectual articles as this, in the future I may do so. Thanks, it is greatly appreciated.

  7. Daniel (1 year ago) Is this Spam?

    Your market decline conclusions will obviously prove right or wrong based on whether your assumptions about earnings are right or wrong. Given all the 100s of billions of dollars governments everywhere are pouring into the global economy via stimulus packages I have a hard time believing the market is not going to benefit to the upside sometime over the next 6-12 months. But who knows? Unfortunately, all I can say for sure is that since last fall, almost every time I hear someone making a strong case - whether bullish or bearish - that sounds truly convincing to me and I follow their reasoning and apply it to my investment decisions the opposite happens and I lose. I am frustrated, discouraged and almost ready to give up while I still have something left.

  8. Andrew (1 year ago) Is this Spam?

    What we have here are two variables - price and earnings. What if both price and earnings were to decline at the same rate? Both 826/46 and 414/23 would give a PE of 18. So would one still wait for PE to decline when S&P is at 414?



    We expect price to decline *faster* than earnings when earnings decrease in order to lower PE, but will this be the case?



    Also, how are the earnings in an index weighted? I am skeptical of earnings figures in an index as it is an aggregate of earnings of many different companies with various earnings histories. Could not a decrease in earnings of just a single company with previously high earnings cause the earnings for the index to drop?

  9. David (1 year ago) Is this Spam?

    Chris I absolutely agree with your logic if a stock is trading above it's underlying tangible asset value.

    However when you value any asset you also have to look at it's tangible book value particularly when much of the decline in earnings recently is arising from the write of of non cash items such as intangibles or provisions against losses that may never be incurred. What is more, how much were those S&P 500 earnings reduced by losses of companies, because the method for valuing a company currently losing money is based on it's current tangible asset value and it's future potential earnings. That is why a lot of people look at enterprise value/ebitda or market value/cash flow rather than p/e.

    So the logic that a companies p/e should be lower if it's earnings are falling does not apply to an index because the individual companies contained in the index each need to be valued independantly generally giving rise to a situation where, when earnings are falling, the p/e of an index rises.



    From that perspective if you can buy something today for less than 50% of it's breakup value, and are going to incur say 20% costs in selling it, is it a good buy or should you be selling it lower?

    So maybe those comments that America is on sale are correct.

  10. Roger (1 year ago) Is this Spam?

    If anyone thinks we are NOT in a full blown global

    depresiion (that we will call GDII just as we called "The Great War" WWI when WWII came along)

    they have another think comming- Just GOOGLE "The Solar Mortality Theory" and read 4 blogs that had predicted GDII to start |2007.5, mid-summer'07.

    Did it? That's when the first major bank failed.

    Be aware, the US has ZERO population growth now.

    Thats not the problem, its the conjunction of 3

    generations, sun-synchronized so no one is works

    aged, newborn and retirees,all sucking equity to

    live and no one investing, so supply & demand

    means no buyers and everyone is selling, GDII

    Pretty simple if you have a brane & know history

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