March 22, 2010These forecasted operating margins are important to investors who rely on using a P/E multiple based on forward earnings. Even with these forecasts for near-record profit margins, valuations on forward operating earnings are not favorable. The current multiple is about 14.8. As John Hussman has noted , the long-term average P/E ratio based on forward operating earnings is about 12. Taking the 14.8 multiple at face value implicitly assumes that the near-record profit margins assumed by analysts are now the long-term norm. Even a minor lowering of expected profit margins would cause the scale of the overvaluation to widen materially. Considering the aggressive expectations for profit margins, the market's valuation based on expected results may be as stretched as it is on trailing fundamentals. With the 2009 fourth-quarter earnings season just about wrapped up, it's a good time to look forward and highlight the current expectations for earnings growth, and what it might mean for the valuations that are based on those assumptions. Except in relation to bubble valuations between 1997 and 2007 (which have produced flat or negative market returns), the market's valuation looks overpriced based on widely-tracked fundamentals. Whether you look at price-to-normalized earnings, price-to-dividend multiples, price-to-book values, or price-to-sales multiples, they all sit above their long-term averages. The graph below shows the price to sales ratio for the S&P 500 since the early 1960's. The current price-to-sales ratio of 1.28 percent is far above its long-term average (outside of the bubble valuations of 1997-2007) of about .83. Prior to the late 1990's, major market peaks such as 1972 and 1987 were typically marked by a price/sales multiple not much above 1.0. Robert Shiller's cyclically adjusted P/E ratio (based on the 10-year average of earnings) suggests a similar scale of overvaluation. It's currently 21.2 versus a long-term average closer to 16. Given that the Shiller P/E reflects the unusually high average profit margins of the past decade, the implied overvaluation based on the Shiller P/E is somewhat less extreme than suggested by other fundamentals.
Since traditional measures of valuation are broadly overvalued, analysts who are recommending additional equity exposure tend to use P/E ratios based on future estimates for operating earnings. On that measure stocks are still overvalued, but less so. But the current forward operating earnings may be overly optimistic once you back out the assumptions they rely on. More modest assumptions would suggest that the market is overvalued even on forecasted fundamentals. Analysts forecast that the S&P 500 companies will $78 by the end of this year, $93 through next year, and $106 through 2012, based on analyst estimates tracked by Bloomberg. That's an expected jump of 25 percent this year, 20 percent next year, and another 14 percent the following year. Clearly, stock analysts aren't buying the New Normal. As I've noted before, these earnings growth estimates are inconsistent with what the economics community is expecting from the overall economy. Economists are forecasting 3 percent real growth both this year and next, with about 2 percent inflation. Corporate earnings typically grow more quickly than the economy when coming out of a recession, especially when profits take the kind of hit that they have experienced the last couple of years. But the ratio of expected earnings growth over the next few years versus expected economic growth still sits far outside of the average ratio of the two (see: Earnings Growth Forecasts May Require a Robust Economic Recovery ) But the aggressive expectations in forecasted earnings growth rates rest not only in corporate performance detaching from the economic climate, but also from corporate fundamentals veering far from their long-term typical performance. The clearest example of this is in the expectations for profit margins. While earnings growth expectations are steep, sales growth expectations are more modest. Sales-per-share for S&P 500 companies is expected to grow about 5.5 percent this year and about 7 percent next year, according to forecasts. The difference between the growth rates of the top and bottom lines is implies a forecast for sharply rising operating profit margins. The graph below is updated from an earlier piece, and includes forecasts through the end of 2012. It plots the long-term level of S&P operating margins in blue. In red, I've plotted the operating margins currently being forecasted by analysts based on their projections for sales and earnings. Last October, analysts were about half way to pricing in profit margins that matched the record levels of 2007. Now, they are just about there.
These forecasted operating margins are important to investors who rely on using a P/E multiple based on forward earnings. Even with these forecasts for near-record profit margins, valuations on forward operating earnings are not favorable. The current multiple is about 14.8. As John Hussman has noted , the long-term average P/E ratio based on forward operating earnings is about 12. Taking the 14.8 multiple at face value implicitly assumes that the near-record profit margins assumed by analysts are now the long-term norm. Even a minor lowering of expected profit margins would cause the scale of the overvaluation to widen materially. Considering the aggressive expectations for profit margins, the market's valuation based on expected results may be as stretched as it is on trailing fundamentals. To continue reading, go here. (c) Hussman Funds
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