Jeremy Siegel, Ph.D. The Future for Investors

I knew that my last article in Yahoo! Finance, “Why Stocks are Dirt Cheap,” would elicit strong opinions, but little did I imagine how controversial it would prove to be! The column attracted comments ranging from “Off with his head!” to “Bravo!”

The article also attracted considerable attention from finance professionals. Henry Blodget disagreed with my analysis, stating that other well-known financial analysts, such as Jeremy Grantham, John Hussman, Andrew Smithers, and my good friend Robert Shiller of Yale University, put fair value of the S&P 500 Index around 1000, far below where I think it should trade. Ned Davis Research, a well known and respected research firm, also took exception to my earnings estimates.

I have nothing but the highest respect for all these individuals and I believe their work must be taken seriously. But I believe their criticisms are wrong and here I explain why I get a significantly higher fair value estimate for stock values than they do.

Trend Earnings

In last month’s article, my fair-value estimate for the S&P 500 Index was derived from a “normalized” earnings of $92 a share for the S&P 500 Index times a 15 average price-to-earnings ratio for the stock market. “Normalized” earnings are earnings stripping away the effects of business cycle, so that normalized earnings are higher than actual earnings in recessions, such as now, and lower at the top of booms. Currently, Standard and Poor’s is projecting that operating earnings for the S&P 500 Index in 2008 will be $64.14 while reported earnings, which contains very large write-offs from a few firms, are at $49 per share.

My estimate of $92 for normalized earnings drew considerable criticism, partially because it was based only on earnings over the past 18 years. If one looks at considerably longer-term time spans, some believe the trends forecast much lower earnings. 

The farthest back we have historical earnings is 1872, based on valuable data that Prof. Robert Shiller brought to light in his book Market Volatility, published in 1989.  These historical data are based on splicing together data from Standard and Poor’s that goes back to 1928 to earlier data compiled by Cowles Foundation researchers.

The graph below depicts those earnings per share data for the US stock market from 1872 through the present, corrected for inflation. Looking at this graph, it certainly appears that earnings over most of the past 20 years have been far above average and that these earnings may now correct to the mean of only $56.40 per share, not far from reported earnings projections this year.  If we apply the historical P-E ratio of 15 to $56.40, we get a projected level of the S&P 500 Index of only 840.

Flaw in Analysis

But there is an important flaw in using a single trend line to project the future.  Doing so assumes that there has been a constant growth rate of real per share earnings over the entire period, an assumption that depends, among other factors, on an unchanging dividend policy of firms.

Yet dividend policy of firms has changed dramatically.  The ratio of dividends paid to earnings, called the payout ratio, has dropped significantly over the past thirty years.  The decline in the payout ratio has substantially boosted the growth rate of earnings per share.  Failure to take this into account will result in a serious underestimate of trend earnings.

The table below confirms that the fall in the payout ratio has boosted earnings growth.  The shift in dividend policy took place in the early 1980s when firms, because of  liberalized rules for share repurchases, taxes favoring capital gains, and the proliferation of management stock options, reduced the amount of earnings paid out as dividends.  The average payout ratio before 1982 was 64.7%, about 40% higher than the 46.6% payout ratio after 1982.  As the payout ratio declined, the dividend yield declined and the growth of earnings accelerated. 

Finance theory predicts, and historical data confirms, that if a firm pays a lower proportion of its earnings as dividends, then these unpaid earnings must be used to either repurchase shares, lower debt, or invest in capital.  In any of these cases, per share earnings growth will increase.

A higher rate of earnings growth from lowering the dividend does not imply that investors obtain a higher return on their investment when management lowers the dividend payout.  The return to shareholders is the sum of the dividend yield and price appreciation.  On average, a dollar of retained earnings will yield investors a return that compensates the investor for the lost dividend income.  But dividend policy will impact earnings growth.

A higher rate of earnings growth also means that using “smoothed” earnings, derived by averaging ten years’ of past data as Prof. Shiller and others advocate, will yield a distorted valuation of the market.  If earnings growth has accelerated, the average of the past ten years will result in a greater underestimate of earnings in more recent decades.

Look back at the long-term chart again.  A new trend line has been drawn covering the period of faster earnings growth that occurs after 1981. According to the new trend, the normalized level of 2009 earnings is a far higher $87.66 than predicted by the single trend line. This earnings figure is slightly below the $92.00 that I estimated in my previous article using analysis over the past 18 years, but it is not appreciably different.

If we apply a 15 P-E ratio to $87.66 level of earnings, we get a fair value of the S&P 500 Index at 1315, almost 50% above the level the market closed on the Wednesday before Thanksgiving.  Furthermore, with the ten year government bond rate falling below 3%, we are in the lowest interest rate environment we have had over the past 50 years.  Normally, when interest rates are this low, stocks sell for a higher-than-average P-E ratio.  To obtain 1380 fair value of the market that I estimated last month, the P-E ratio would need to be less than one point above its long run average of 15.

Objections to My Analysis

Some analysts, such as Robert Arnott and Peter Bernstein have claimed that earnings do not grow faster when the payout ratio is reduced since the retained earnings are wasted on unproductive investment and excess executive compensation.  Yet the higher earnings growth from 1981-2007 contradicts their objections.

Others may object to my use of “operating earnings” rather than reported earnings, in making my projection. Operating earnings exclude some of the big write-offs that arise from restructuring, pension revaluations, impairment charges, and portfolio losses, although they do include many of the recent write-offs of financial firms.

Although operating earnings are only reported back to 1988, the earnings data before that date are, according to sources I have contacted at Standard and Poor’s, closer to the concept of operating earnings than reported earnings.  This is because FASB has sharply increased the number and type of charges that firms must write off and this has depressed reported income, especially during recessions. 

Other Distortions in Earnings Data

The increasing number of large write-offs has also led to a distorted look at the earnings levels for the S&P 500 Index.  In another article, I have discussed how there are major distortions in the official earnings numbers provided by index providers like S&P. Six firms (AIG, Wachovia, Sprint, GM, Merrill Lynch, and Citigroup) with over $170 billion dollars in losses over the past year, lowered aggregate earnings on the S&P 500 Index by nearly $20 per share.  Yet these firms are tiny and represent less than 1% of the S&P 500 by weight. That is to say over 99% of the S&P 500 had earnings that were closer to $70 per share when the officially reported results are more like $50 per share.

I have proposed a new method for calculating earnings for the index that more logically takes into account the weight of each firm in the index when considering their earnings or losses. Using a weighted average method for estimating earnings for the S&P 500 index, I find that trailing 12-month reported earnings on the S&P 500 are closer to $78 per share and operating earnings are $83, despite the economic slump.  Using the $83 figure and my 1380 fair value estimate of the S&P 500, would give only a 16.6 times P/E ratio, a conservative valuations given the very low interest rate environment.

Bottom Line

I maintain that the stock market is significantly undervalued even when you use very long-term trends to analyze earnings growth. Moreover, the officially reported results are understating the true profitability of the market. The low level of stocks today is not a result of investors expecting current depressed levels of earnings will persist, but rather a result of record risk premiums in the debt and equity markets. When these extraordinary risk levels return to normal, we can expect much higher stock prices.