Prudential Financial Research - Stock Valuation Models, risk

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Research
STOCK VALUATION
MODELS (4.1)
January 6, 2003
Topical
Study
#58
All disclosures can be found on the
back page.
Dr. Edward Yardeni
(212) 778-2646
ed_yardeni@prusec.com
75
Figure 1.
STOCK VALUATION MODEL (SVM-1)*
(percent)
75
65
65
60
60
55
55
50
50
45
45
40
40
35
35
30
30
25
25
Overvalued
20
20
15
15
10
10
5
5
0
0
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
-30
-30
Undervalued
-35
-35
12/27
-40
-40
-45
-45
-50
Yardeni
-50
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06
* Ratio of S&P 500 index to its fair value (i.e. 52-week forward consensus expected S&P 500 operating
earnings per share divided by the 10-year U.S. Treasury bond yield) minus 100. Monthly through March 1994,
weekly after.
Source: Thomson Financial.
70
70
R E S E A R C H
Stock Valuation Models
I. The Art Of Valuation
Since the summer of 1997, I have written three major studies on stock valuation and numerous
commentaries on the subject.
1
This is the fourth edition of this ongoing research. More so in
the past than in the present, it was common for authors of investment treatises to publish
several editions to update and refine their thoughts. My work on valuation has been acclaimed,
misunderstood, and criticized. In this latest edition, I hope to clear up the misunderstandings
and address some of the criticisms.
I do not claim to have invented a scientific method for determining the one and only way to
judge whether the stock market is overvalued or undervalued. Rather, my goal is to provide
variations of a stock valuation model that can generate useful monthly and even weekly
guidelines for judging the valuation of the stock market. Nevertheless, I believe valuation is a
subjective art much more than it is a mathematically precise objective science.
In my earlier work, I focused on developing empirical methods for valuing the overall stock
market, not individual stocks. Valuation is a relative exercise. We value things relative to other
things or relative to a standard of value, like a unit of paper money (e.g., one dollar) or an
ounce of gold. Stocks as an asset class are valued relative to other asset classes, like Treasury
bills (“cash”), bonds, real estate, and commodities. In my valuation work, I focus primarily on
the valuation of stocks relative to bonds. This means that the models can also be useful in
assessing the relative value of bonds.
This fourth edition incorporates most of my analysis and conclusions from my previous
research, which was based on 12-month forward consensus expected earnings for the S&P 500.
The data are available both on a weekly and monthly basis. It is widely recognized that stock
prices should be equivalent to the present discounted value of
expected
earnings, not trailing
earnings. Yet a few widely respected investment analysts base their valuation work on trailing
earnings and often derive conclusions that are quite different from the models based on
forward expected earnings. As discussed below in Section V, I do monitor the backward-
looking models, but I don’t think they are especially helpful in explaining the valuation of
expected earnings. The advocates of trailing earnings models do have the choice of using either
reported earnings or operating earnings, i.e., excluding one-time writeoffs. Of course, the more
pessimistically inclined analysts focus on reported earnings, the lower of the two measures. In
either case, the data are available only on a quarterly basis with a lag of several weeks.
A similar data delay is experienced by analysts who believe that valuation should be based on
quarterly dividends rather than forward earnings. I have added Section IV, which discusses the
importance of dividends in assessing stock market valuation. I am amazed that critics of models
based on forward earnings claim that they didn’t work prior to 1979, which happens to be the
first year that such data became available! As I will explain below, there is at least one good
1
More information is available in
Topical Study #56
, “Stock Valuation Models,” August 8, 2002,
Topical Study
#44
, “New, Improved Stock Valuation Model,” July 26, 1999 and
Topical Study #38
, “Fed’s Stock Valuation Model
Finds Overvaluation,” August 25, 1997.
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January 6, 2003
R E S E A R C H
Stock Valuation Models
reason to believe that dividends mattered more than earnings prior to the 1980s. Dividends may
matter more again if the double taxation of dividends is either eliminated or reduced.
So how can we judge whether stock prices are too high, too low, or just right? Investment
strategists are fond of using stock valuation models to do so. Some of these are simple. Some
are complex. Data on earnings, dividends, interest rates, and risk are all thrown into these
black boxes to derive a “fair value”
for
the stock market. If the stock market’s price index
exceeds this number, then the market is overvalued. If it is below fair value, then stocks are
undervalued. Presumably, investors should buy when stocks are undervalued, and sell when
they are overvalued.
Previously, I examined a simple stock valuation model, which has been quite useful (Figure 1).
I started to study the model after reading about it in the Federal Reserve Board’s
Monetary
Policy Report to the Congress
of July 1997. I dubbed it the “Fed’s Stock Valuation Model
(FSVM),” though no one at the Fed ever officially endorsed it. To avoid any confusion that this
is an official model, in my recent research reports I have renamed it “Stock Valuation Model #1
(SVM-1).” This nomenclature is also meant to indicate that there are plenty of alternative SVMs
as discussed in Section V.
Barron’s
frequently mentions SVM-1, especially since 9/11. The cover page of the September
24, 2001, issue observed that the stock market was “the biggest bargain in years.” The bullish
article, titled “Buyers’ Market” and written by Michael Santoli, was entirely based on the SVM-1,
which showed that stocks were extremely undervalued when the New York Stock Exchange
reopened for trading on September 17, 2001.
A model can help us to assess value. But any model is just an attempt to simplify reality, which
is always a great deal more complex, random, and unpredictable. Valuation is ultimately a
judgment call. Like beauty, it is in the eyes of the beholder. It is also a relative concept. There
are no absolutes. Stocks are cheap or dear relative to other investment and spending
alternatives. A model can always be constructed to explain nearly 100% of what happened in
the past. “Dummy variables” can be added to account for one-time unpredictable events or
shocks in the past. However, the future is always full of surprises that create “outliers,” e.g.,
valuations that can’t be explained by the model. For investors, these anomalies present both the
greatest risks and the greatest rewards.
More specifically, most valuation models went on red alert in 1999 and 2000. Stocks were
grossly overvalued. With the benefit of hindsight, it was one of the greatest stock market
bubbles ever. Investors simply chose to believe that the models were wrong. The pressure to go
with the flow of consensus sentiment was so great that some strategists reengineered their
models to show that stocks were still relatively attractive. One widely followed pundit simply
replaced the bond yield variable with the lower inflation rate variable in his model to
accomplish the alchemy of transforming an overvalued market into an undervalued one.
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January 6, 2003
R E S E A R C H
Stock Valuation Models
During the summer of 1999, I did fiddle with the simple model to find out whether it was
missing something, as stocks soared well above earnings. I devised a second version of the
model, SVM-2. It convinced me that stocks were priced for perfection, as investors seemed
increasingly to accept the increasing optimism of Wall Street’s industry analysts about the long-
term prospects for earnings growth. The improved model also demonstrated that investors were
giving more weight to these increasingly irrational expectations for earnings in the valuation of
stocks! As I will show, analysts have been slashing their long-term earnings growth forecasts
since early 2000, and investors are once again giving very little weight to earnings projections
beyond the next 12 months.
2
The question during the fall of 2002 was whether investor sentiment had swung too far from
greed to fear. According to SVM-1, stocks were 49% undervalued in early October. This was the
most extreme such reading on the record since 1979. Despite an impressive jump in stock
prices at the end of October and through November, SVM-1 has become quite controversial.
The bears contend that the model is flawed. Stocks are not undervalued at all, in their opinion.
They believe stocks are still overvalued and may fall much lower in 2003. Ironically, not too
long ago, it was the bulls who declared that stocks were not overvalued, and offered lots of
reasons to ignore SVM-1.
I believe that the model is still useful and should not be ignored. Nevertheless, it should be only
one of several inputs investors use to assess whether it is a good or bad time to buy stocks. For
example, while SVM-1 indicated that I should increase my recommended exposure to equities
in June and July of 2002, I went the other way: I lowered my exposure from 30/70 bonds/stocks
to 35/65 for a Moderately Aggressive investor. For a Moderate investor I changed my
recommended cash/bonds/stocks allocation from 10/40/50 to 10/50/40. I did so because I
concluded that investors might continue to worry about the quality of earnings after WorldCom
disclosed on June 26, 2002, that the company’s earnings for the past several quarters were
overstated as a result of fraudulent accounting.
I have one more warning before proceeding: Neither SVM-1 nor SVM-2 is likely to work if
deflation becomes a more serious problem for the economy and earnings. According to SVM-1,
the fair-value P/E is equal to the reciprocal of the Treasury bond yield. So the P/E should be 25
now with the bond yield at 4%. But why would investors be willing to pay such a high multiple
for the lackluster earnings environment implied by such a low bond yield? I believe we have a
better chance of seeing a 20 multiple if the bond yield rises to 5% and stays there than if the
bond yield remains at 4%. If instead, the bond yield continues to fall, suggesting that deflation is
proliferating, then the valuation multiple might actually fall, too.
In my
Topical Study #44
, “New, Improved Stock Valuation Model,” dated July 26, 1999, I wrote, “My analysis
will demonstrate that the market’s assumptions about risk, and especially about long-term earnings growth may be
unrealistically optimistic, leaving it vulnerable to a big fall….The stock market is clearly priced for perfection. If
perpetual prosperity continues uninterrupted, then perhaps the market’s exuberant expectations will be realized. I,
however, see more potential for disappointment, given the extreme optimism about long-term earnings growth
embedded in current market prices.”
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January 6, 2003
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