Many people are wondering whether the market is now undervalued, based on price-to-earnings ratios and interest rate models.  Many of these models are undeniably robust and have demonstrable predictive value.  But, at their core, they are approximations.  They offer shorthand solutions that can’t fully address whether the market properly reflects the intrinsic value of its constituents.

One way to avoid approximating is to use a discounted cash flow (DCF) model to calculate the fair value of each company in the index.  This approach duplicates that of a would-be acquirer who invests based on the present value of future cash flows.

The Applied Finance Group (AFG), a Chicago-based independent equity research firm, regularly performs this analysis.  They have built the analytical tools to determine the intrinsic value of over 4,500 securities traded in the marketplace.

Rafe Resendes, the founder of AFG, says a fair value for the S&P 500 is just under 1,000, approximately 20% above today’s level.

Resendes’ projects the free cash flow for each company in the S&P then discounts these cash flows to arrive at a present value.  In determining the present value, he also solves for the rate of revenue growth that is necessary to equate the present values of the index constituents to the current value of the index.

According to Resendes’ model, the S&P is now priced to reflect a negative 6% annual growth in revenues for the next 5 years.  Of the 500 companies in the S&P, over 150 are priced to reflect negative sales growth. 

Resendes says this 6% revenue contraction is unrealistic – much worse than even the direst projections for the economy, based on GDP contraction.

AFG has been providing market valuations since 1995, and the company uses its tools to identify the cheapest and most expensive stocks – those whose market prices differ most significantly from their calculated valuations.  The stocks with the most reasonable expectations, Resendes says, consistently outperform the market, while those with the most unreasonable expectations consistently underperform.

In March of 2000, at the peak of the Dot Com boom, AFG models gave signals completely opposite to those Resendes is seeing now.  Back then, AFG estimated that the average company in the S&P had to grow sales 22% annually to justify its valuation – an assumption Resendes considered preposterous at the time.  Only 12 companies were priced to deliver negative sales then. 

It was “emotionally very easy to invest then, with the economy humming along, unemployment down, and new records for profitability being set each quarter,” he says, but financially it was a very bad time to invest.

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