I’m not a big fan of using PE ratios to determine fair value estimates for the S&P 500. If I do use earnings, I believe the 10-year average is more appropriate in order to capture the business cycle and even then its to estimate projected long-term returns. I should note that Shiller’s CAPE, which does just that, has come under serious attack as the multiples have been above the long-term average for many years now (and beginning back in the 1990s). For now we will pass on defending the validity of the CAPE and turn to working with a real-time valuation tool.
We can value the S&P 500 using a simple 5 year discounted cash flow model. The model requires us to estimate a) current cash flow, b) growth of cash flows, and c) discount rate. There are many ways to come up with these estimates and the following is one way that we can look at it.
Current Cash Flow: Current cash returned to shareholders (dividends and buybacks) was estimated at $96.20 per share in the trailing twelve-months ended in March. I am currently estimating $95.52 in the trailing twelve-months ended in June.
Growth: I am using the fundamental formula that considers all cash retained by corporations (retention ratio) is reinvested grows at the retention ratio times the return on equity. Using a 10-year average retention ratio of 18% and a 10-year average return on equity of 14.6%, I am using a fundamental growth estimate of ~2.6%.
Discount Rate: This is likely the most subjective estimate. Equity risk premiums (ERP) seem to be somewhat volatile. Saying that we are using a 5.0% ERP and a 2.5% yield on the 10-year treasury for a discount rate of 7.5%. We can change the ERP estimate to see the level of sensitivity to our inputs.
With that all plugged into the 5 year discounted cash flow model, one should see a fair value of 1,970. This compares to the recent market price of 1,991. If we lower the ERP to 4.8% the estimated value jumps to 2,034.
This leaves us with some comfort that on a fundamental basis that the S&P 500 is likely not significantly over valued. Outside of unexpected macroeconomic shocks, the risk to these estimates in my opinion is based on the relative level of earnings compared to sales, otherwise referred to as corporate profit margins. A more detailed cash flow analysis which separates revenue growth and operating income growth can highlight the large impact bottom performance can be dictated by changes in corporate profitability. Right now corporate profit margins are on the high side and likely will provide little upside moving forward.