Research--E. Yardeni, Deutsche Bank: "How To Value Earnings Growth"
yardeni.com
Topical Study #49
How To Value Earnings Growth
Dr. Edward Yardeni
Chief Economist
January 31, 2000
>>>I. New Improved Valuation Model
The bears believe that the US stock market is overvalued. They see a speculative bubble. The bulls
say that the bubble bears are using traditional valuation models which are irrelevant in the New
Economy. Neither side has provided a very rigorous defense of their position, in my opinion. In this
study, I will use a traditional valuation model to derive the explicit bullish assumptions embodied in
stock prices. I will show that the market is fairly valued today only if record-high, long-term earnings
growth expectations are realistic and should be given more weight than in the past (Exhibit 1).
The model can also be used to compare the market’s actual price-to-earnings ratio to the
theoretical relationship between earnings growth and valuation. Again, current ratios make sense
only using some very bullish assumptions about the outlook for earnings growth.
The simplest model is the Fed’s Stock Valuation Model (FSVM). This model is inspired by the
close historical empirical relationship between the current earnings yield (CEY) of the S&P 500
index and the 10-year Treasury bond yield (TBY) (Exhibit 2). The current earnings yield is the 12-month
consensus forward earnings expectations (E) divided by the S&P 500 index (P). The
earnings data are compiled by I/B/E/S International. When the stock market’s current yield is
greater (less) than the bond yield, stocks are under- (over-) valued.
This simple model worked quite well in the past. It identified when stock prices were excessively
overvalued or undervalued, and likely to fall or rise. It hasn’t worked very well since May 1999,
when the market surpassed its previous record 34% overvaluation peak just prior to the 1987
crash. Instead of falling, stock prices continued to soar. Today, the FSVM shows that stocks are
more than 60% overvalued (Exhibit 3).1
The FSVM is missing variables reflecting that the current earnings yield is riskier than the
government bond yield. Also missing is a variable for long-term earnings growth. The New
Improved Model includes these variables as follows:
1) CEY = CBY – b · LTEG + residual
where CBY is Moody’s A-rated corporate bond yield. LTEG is long-term expected earnings
growth, which is measured using consensus five-year earnings growth projections. These are
compiled monthly by I/B/E/S International, and hit a record high of 15.7% during December
(Exhibit 4). The “b” coefficient is the weight that the market gives to long-term earnings projections.
It can be derived as -[CEY-CBY]/LTEG. Since the start of the data in 1985 until 1999, this
“earnings growth coefficient” averaged 0.1 (Exhibit 5).
II. New Economy Assumptions
Equation 1 can be rearranged to produce the following equation:
2) P’ = E ¸ [CBY – b · LTEG]
where P’ is the fair-value price of the S&P 500 index. Exhibit 1 shows three fair-value price series
using the actual data for E, CBY, and LTEG with b = 0.1, b = 0.2, and b = 0.25. The market is
fairly valued today if you agree with the consensus forecast that earnings can grow 15.7% per year
over the next five years and that this variable should be weighted by 0.25, or two and a half times
more than the average historical weight.
These are certainly New Economy assumptions. They raise two questions:
1) Can profits grow so rapidly over the next five years?
2) Should we give more weight than in the past to long-term earnings forecasts?
Previously, I showed that, on a trend basis, corporate profits have grown at the same pace as
nominal GDP, i.e., revenues. The only way that profits could grow faster would be if the profit
margin trended higher. This can happen on a cyclical basis, of course, but the historical trend has
been a flat one for profit margins.2
I doubt that nominal GDP can grow faster than 5% to 6% per year over the next five years. This
assumes that real GDP will grow 4% per year, with inflation between 1% and 2%. So how can
profits increase 16% per year? The answer is it can happen because the GDP measure of profits is
an unweighted aggregate, while the New Improved Model uses a measure that is market-cap
weighted. In the New Economy’s stock market, the stocks with the fastest earnings growth rates
are the ones with the biggest and fastest growing market capitalization. This is a radical change from
the past, when small companies had the fastest earnings growth.
Of the two New Economy assumptions, I believe that it does make sense to give long-term earnings
expectations more weight in valuing stocks. The model I am using has no explicit risk premium
factor for stocks versus bonds. It is partly reflected in the credit-risk premium in the A-rated
corporate bond yield versus the Treasury bond. It is also implicit in the weight the market assigns to
long-term earnings expectations. If recessions are likely to be less frequent and shallower in the
New Economy, then we should give more weight to long-term earnings expectations.
III. How Much Is Growth Worth?
Equation 2 above can be rearranged to derive fair-value price-to-earnings ratios (P/Es):
3) P’ / E = 1 / [CBY – b · LTEG]
Tables 1 and 2 and Exhibits 6 through 11 show these P/E ratios for various bond yields, earnings
growth rates, and earnings growth coefficients. The current P/E, as of January 27, 2000, is 24.1,
using 12-month forward earnings of $58.09 per share and an S&P 500 index of 1398.56. Is this
too high? The tables show how difficult it is to answer this question. It all depends on how fast you
think earnings can grow and how much weight you are willing to give your forecast. For example, a
growth rate of 15% with a 7% corporate bond yield can be worth 18x earnings with a 0.1 weight or
40x with a 0.3 weight. You can drive a convoy of trucks sideways between those two points. A
10% earnings growth rate with a 7% yield can be worth 17x earnings with a 0.1 weight or 25x with
a 0.3 weight.
Valuation, LIKE BEAUTY, is in the eye of the beholder. This exercise has demonstrated how widely
valuation can vary with relatively small changes in the key variables. Valuation models are still useful for identifying the assumptions about earnings growth and risk that are embodied in stock prices. But, at the end of the day, we all have to judge on our own whether those assumptions are overly bearish or overly bullish.
In my judgment, the overall market is probably fairly valued now.
However, since the middle of 1998, the stock market has split into a small group of overpriced
growth stocks and a big group of underpriced value stocks. This year, I expect a convergence of
these valuation extremes.<<< |
