Why Fair Value For The S&P 500 Is Not 440

Barry Ritholtz, market veteran and blogger over at The Big Picture postulated today that fair value for the S&P 500 might be 440. He got there by taking trailing 12 month GAAP earnings of $28.75 and applying a 15 P/E ratio to them.

Personally, I expect more from Barry given how strong much of his market and economic analysis has been over the years, but there are glaring flaws in this valuation methodology. First, I don’t know very many market strategists who believe fair value on the S&P 500 should be based on the earnings produced by the index’s components in the depths of a deep recession. Most people agree that fair value should be based on an estimate of normalized earnings, not trough (or near-trough) profit levels.

Imagine you owned a Burlington Coat Factory retail store. You are ready to retire and have a business person interested in buying your store. What would your reaction be if this person took your store’s profit for the month of June, multiplied it by 12, and based his offer price on that level of projected annual profits. Clearly that figure does not give an accurate representation of how much money your store earns in a year because June is probably one of your worst months of the year for selling coats!

The same flaw exists in valuing the stock market based on current earnings. Doing so implies that earnings today represent a typical economic climate, which is clearly not the case.

The second issue with Barry’s analysis is the use of “as-reported” GAAP earnings. The reason GAAP earnings have fallen so fast is that they include non-cash charges such as asset impairments. It is common these days for companies to report cash earnings of $1 billion but a GAAP loss of $5 billion due to a $6 billion asset impairment charge. In such a case GAAP earnings (which include the non-cash charge) are understated by a whopping $6 billion. Why should asset impairments be excluded? A stock’s value is based on the present value of future free cash flow. Since cash flow is what matters to investors when valuing the market and specific stocks, non-cash accounting adjustments (such as asset impairments) don’t really play a role in fair value estimations.

The interesting thing is that you don’t have to take my word for it on this topic if you don’t want to. The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings (S&P 500 at 834 divided by 28.75) is excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.