In an earlier article, we showed how the range and types of earnings estimates in combination with very long-term historic P/E multiple norms could support guesses about the year-end 2009 S&P 500 price level anywhere between 500 and 1500.  It was somewhat of a pick your poison conclusion.

One reader complained that use of historical data is “absurd” and that only a discounted future cash flow is appropriate for valuation.  We have enough problems believing in current and forward year estimates without trying to do a 10 to 30 year projection.  So, we’ll leave that approach to the academic classroom and to those who think that is a productive approach — we do not.

Another reader appropriately commented that if you use normalized P/E ratios, you ought to use normalized earnings as well.  That seems like a reasonable position to take.  Let’s see how that might play out for 2009.

Ten Years of History and Two Years of Future:

Here are the “as reported” (all in) earnings for the S&P 500 index provided by Standard and Poor’s.  The list shows ten years of actual historical reports, and two years of projections by Standard and Poor’s

• 2010: $41.49 estimate
• 2009: $34.74 estimate
• 2008: $14.97
• 2007: $66.18
• 2006: $81.51
• 2005: $69.93
• 2004: $58.55
• 2003: $48.74
• 2002: $27.59
• 2001: $24.69
• 2000: $50.00
• 1999:  $48.17

“Normalized” Earnings:

There are probably many different ways to “normalize” earnings.  We don’t profess to know what all of those may be, or that the four approaches we provide here are representative of the normal way to normalize.  However, the earnings figures below are multi-year in character and should go a long way to eliminate the problems associated relying on trough earnings years in the valuation process.

To prevent this work from being confused with other methods, or being challenged as not consistent with other methods, we’ll use our own label to give us latitude with “normalization” purists.  We’ll use the term: “synthetic earnings”.

Synthetic Earnings A (10 years):

8 years of actual history (each successive year increased by 2% for inflation) + 1 current year estimate + 1 forward year estimate = $49.43 per index share.

Implied 2009 index level -

• at 10 X = 494
• at 15 X = 742
• at 20 X = 989

Synthetic Earnings B (10 years):

10 years of actual history (each successive year increased by 2% for inflation) = $53.54.

Implied 2009 index level -

• at 10 X = 534
• at 15 X = 801
• at 20 X = 1069

Synthetic Earnings C (5 years):

3 years of actual history (each successive year increased by 2% for inflation) + 1 current year estimate + 1 forward years estimate = $48.70.

Implied 2009 index level -

• at 10 X = 487
• at 15 X = 731
• at 20 X = 974

Synthetic Earnings D (5 years):

5 years of actual history (each successive year increased by 2% for inflation) beginning with 2007 (to exclude the entire effect of the 2008 earnings problem) = $68.74.

Implied 2009 index level -

• at 10 X =687
• at 15 X = 1031
• at 20 X = 1375

Summary:

This method tightens the range from 500/1500 to 500/1400.  Realistically, though, we think it suggests something more like 500 to 1000.  That’s because we have to entirely deny the current situation in order to get to the 1375 optimistic 20X high in Synthetic Earnings D.

It’s a reasonable thing to take multi-year trends into consideration to capture the concept of a business cycle, but it is unreasonable to exclude the worst data entirely from the “normalization” process.  We are in a problem period.  We are likely to be in a problem period for an abnormally long time.  We need to moderate our earnings cycle expectations as a result.

Probably a “normalized” earnings approach would suggest a 500 to 1000 level for the S&P 500 by year-end 2009.

Richard Shaw
QVM Group LLC

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