Why The Equity Market Still Looks Good Value

Posted on 20/12/2010

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An regularly quoted measure in order to estimate whether or not the equity market represents good value is the price/earnings ratio (ie. the price of the overall stock market relative to the current year’s forecast earnings).  This makes sense given that shareholders are paying for the stream of earnings that the companies in the index will generate in the future.  Investors typically use rules of thumb to determine what is – or what is not – an attractive valuation multiple.  Some investors use the data from Shiller, which compares the current share price of the S&P 500 to the trailing earnings to the last ten years.  At present, the market is trading at 22.7x compared to the long-term mean of 16.4x, and many investors will take this as a sign that the the market is overvalued and will return to the mean.  However, the correct P/E multiple to pay for a particular investment can be determined by mathematical formula.  That formula is: (dividend pay-out ratio in the coming year)/(cost of equity minus long-term earnings growth rate).  From this formula, we can see that when the cost of equity capital is lower, investors should be justified in paying a higher multiple of earnings for equities.

The above chart shows the relationship between the cost of equity capital and the justified P/E ratio.  Not only does the justified P/E ratio increase as the cost of capital falls, but it does so at an increasing rate.  My point therefore, is that in the current era of low interest rates, investors should be willing to pay much higher ratios of earnings in order to hold equities.  For the dividend pay-out ratio we use 33%, which is roughly in-line with the previous decade, while for the long-term earnings growth rate we use 6%, in-line with the experience of the last twenty-five years.  Currently, according to Credit Suisse, the S&P 500 is trading at a multiple of 13x FY11 earnings, a level which implies a cost of equity capital of 8.6%.  A survey of chief financial officers by Graham & Harvey during the period 2000-05 found that the equity risk premium above the 10-year Treasury Bond was 3.66%.  Assuming this still holds, and given the 10-year Treasury Bond yield is currently 3.33%, then this suggests a total equity cost of capital of 7.01% and the fair-value P/E ratio for the S&P 500 index is 33x.  On this basis, it is possible to argue that the US equity market is still quite cheap at 13x earnings.

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