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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 214643  
Subject: Re: 40% Overvalued Date: 10/10/2012 9:53 AM
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I cannot find any company that needs to fall by 60% to reach fair value.

That would indeed be a big fall!
(not sure where the 60% figure came from...I'd certainly want to be
prepared for a fall that big or bigger, and I more or less expect it,
but equities will be cheaper than average when that happens).

But in any case, my pointing out that the market is clearly overvalued
is based mainly on the observation that current earnings are near a cyclical highs,
so the table of current P/E ratios tells you very little about valuations.
The point is only slightly that multiples are too high, the bigger issue is that earnings are unsustainably high.
A much more interesting thing would be to look at the ratio of price to
10 or 15 year average of EPS for a bunch of individual firms.

On average over time the EY15 for the broad US market averages about 6.12% (time weighted since 1945),
so the average big company is "fairly" valued at that level.
Convert each of the prior 15 years' EPS into current-day dollars, average those, divide by current price.
For Verizon you get 6.76% which is cheaper than the long run average based on E15,
no problem with that one, but of course their real earnings have been falling steadily for a decade which might be a sensible reason for cheapness.
For PG you get EY15 of 4.27%, 45% more expensive than the long run average for the broad market 6.18%.
It would appear that this one is closer to being typical of the broad market.

Unfortunately, and "average" valuation hides a multiplicity of sins,
as there are always some firms that are [deservedly] cheap and others worth a premium.
You'll get some oddities in the Dow, so it would have to be done with
quite a few big firms before you got a clear idea.
Walmart was unusually undervalued for quite a while, Pfizer had
a huge windfall earnings bubble from Lipitor, Intel just crashed, etc.
The firms in the Dow 30 are not randomly chosen, but rather selected
for their dominance, to they tend to be a little more highly priced
on average than the broad market and probably deserve that.

In any case, if you want to try this yourself with any firms, here are
the multipliers for old EPS to convert them into today's dollars.
end of...
1996 1.453
1997 1.427
1998 1.405
1999 1.369
2000 1.323
2001 1.299
2002 1.271
2003 1.249
2004 1.206
2005 1.166
2006 1.143
2007 1.096
2008 1.085
2009 1.065
2010 1.053
2011 1.019
To get E15 you'd average 1997 through 2011 or 1998 through estimated 2012, au choix.

Broad US real earnings based on E15 rose at a rate of 3.02%/year 1945-1970,
by a rate of only 0.51%/year 1971 through 1995 (!), and 3.25%/year 1996 to date.
The overall rate of real growth of E15 in since 1945 has been 2.17%/year,
a pinch above the very long run rate of just under 2%.
Let's assume that the recent period growth of 3.25% since 1996 is sustained indefinitely, a most optimistic assumption.
Since the long run average E15 earnings yield is 6.18% and the S&P is at 1435,
Thus E15 would have to be at $87.87 in today's dollars for the S&P to be
fairly valued (long run average historical multiple) at today's prices.
That reasoning is very solid with only an extremely small error range.
But E15 is only $61.77 right now, and at 3.25%/year it won't reach
$87.87 (in today's money) till April 2024 extending the 1995-to-date trend.
So, either the market has to fall 30%, or has to be flat for 12 years
while trend earnings catch up with today's prices, or some mix of the two.
That conclusion uses what I believe is an unustainably high estimate of real trend earnings growth.
Also I believe E15 (an imperfect metric) is itself a pinch high right now.

Jim
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