Shiller’s PE misrepresents S&P 500 valuation
The current Shiller PE of 24x is 50% above its 1900-2010 average of 16x. While we would normally take concern with a valuation measure 50% above its long-term average, we encourage investors to ignore this one. We believe Shiller’s $55 inflation-adjusted 10yr trailing avg. EPS is not a fair representation of normalized EPS for 2010 and prefer our $90 Equity Time Value Adjusted (ETVA) 10 yr. avg. EPS. The current ETVA PE of 14.7x is almost a multiple point lower than the 50yr average of 15.6x and is well supportive of our 1400 year-end target.
Shiller’s PE understates normalized EPS
Shiller’s PE cannot be fairly compared across time because it neglects substantial shifts in dividend payout ratios over the last 110 years. Anytime the dividend payout ratio is not 100% EPS should rise with inflation plus the return on reinvested earnings. This is called an Equity Time Value Adjustment (ETVA). Shiller’s EPS does not fairly represent normal EPS because it assumes EPS only grows by inflation, which given a decade of high EPS retention, is flawed.
ETVA 10yr avg. EPS is a better proxy of normalized EPS
We believe our $90 ETVA 10yr avg. EPS estimate is a better representation of normalized EPS for 2010 and supports our 2011 normalized EPS estimate of $95. We advocate a 10yr PE based on 10yr avg. ETVA EPS because the 33% average S&P 500 payout ratio over the past 10 years is significantly lower than its
1900-2010 average of about 60%. While we expect the dividend payout ratio to rise to 38% through 2012 and prefer dividend growth stocks, the payout ratio will still stay well-below average.
Compare today’s S&P 500 to 1960 onwards, not 1900
We prefer to compare today’s PE to averages since 1960. We do not advocate including the 10 years after 1914 in the long-term average 10yr PE as US companies benefitted from supplying Europe in WWI and experienced an exceptional swing in profits not likely to occur again. EPS tripled from 1914 to 1916. By 1921, in the deep post-war recession, profits fell to less than a fifth of the 1916 peak causing the 1921 PE to be 25.2x, but only 5.6x on average 10yr inflation adjusted EPS. Furthermore, the S&P 500 has only existed since 1957.
Pro forma overstates true EPS, but GAAP understates
While Shiller’s PE is based on GAAP EPS, we prefer to use pro forma EPS when making comparisons to EPS reported many decades ago. Since 2000, goodwill and asset write-downs increased owing to the elimination of pooling accounting for mergers and impairment tests for acquired goodwill. GAAP understates true EPS due to the downward bias of these balance sheet adjustments. We apply an accounting quality adjustment to our normalized EPS before using it for valuation to account for pro forma overstating EPS.
Source: Merrill Lynch/Bank of America