Friday, August 25, 2006

Thoughts About Earnings

Thinking out-loud about a few things below:
  • Earnings growth for the S&P 500 for last 2-3 years has been robust. Double-digit earnings growth achieved by the S&P 500 for last 2-3 years.
  • S&P 500 estimates for reported earnings for the fiscal year 2006 stands at $80.37 today.
  • 80.37*15 = 1205.55 is the fair value of S&P 500 at the end of 2006 by taking into account the historical average P/E of 15 based on the trailing 12-month earnings.
  • The current price of S&P 500 is at about 1300. (Does this mean that S&P 500 is about 100 points overvalued? Maybe.)
  • Since the earnings growth has been robust for a last couple of years, it is very hard for the S&P 500 to duplicate the growth in the coming few years.
  • If the earnings growth slows, that does not mean that earnings are zero. (if you watch some financial TV channels or read some articles in paper or online, you might get a sense the sky is falling and earnings are zero or negative.)
  • If earnings do not grow from this year’s $80.37 into next year, and for argument’s sake; if the earnings growth is 0%, then the S&P 500 will in fact earn $80.37 in the year 2007.
  • If 2008 also achieves 0% growth in earnings than we can also expect S&P 500 to earn $80.37 in 2008.
  • In this type of environment the S&P 500 will act as a bond if the P/E does not expand and price does not go up.
  • The yield on this S&P 500 as bond will be 6.15% based on current price of around 1300. (80/1300 * 100 = 6.15).
  • The long-term investment grade bonds are barely yielding 6.15% today.
  • The S&P 500 companies will take in $160 worth of earnings in the profits. Some of these earnings will be paid to shareholders as dividends, some may be used to buy back the stock, and some may be used to pay down debt and so on.
  • There will be some money spent on new capital expenditures and most importantly I think, that the price-to-book value should come down if the price does not go up much.
  • Let’s suppose if you own a business and your profit grew by more than 10% for last couple of years and this business is expected to show steady earnings for the next couple of years; will you sell this business just because it is only a steady business for couple of years, not a high flying one? If your business gave you $100k in profit this year and about to give you same profit in 2007 and 2008, will you just dump it because it does not grow?. Let’s assume that the business growth is projected to be there in the subsequent year after 2008.

Your comments are welcome.

1 comment:

David said...

Interesting analysis. My understanding is that profit, as a % of national income, is running above the historical average (there's a chart o this at bigpicture.typepad.com) and that this particular ratio shows a strong reversion-to-the-mean tendency. So, it's not unthinkable that earning would actually decline for some period of time.

Also, note that, unlike bonds, a stock has no definite maturity, which means it will be more sensitive to inflation *if* it is not able to grow earnings in accordance with same.