January 2014

Jan 2014

PE ratios

Are US companies returning too much cash to investors? It is true that the 84.13% of earnings paid out in dividends and buybacks in 2013 was higher than the average of 79.96% from 2004-2013, but the difference is not large.  The bigger danger to cash flows to equity is a collapse in earnings. In fact, using the CAPE rule book, we estimated the inflation-adjusted earnings on the index each year from 2004 to 2013 and computed a ten-year average of these earnings of 82.64. Applying the average payout ratio of 79.96% to these earnings results in a much lower cash flow to equity of 66.08. Using those cash flows, with an equity risk premium of 4.90%, results in an intrinsic value for the index of 1467.89, about 20.6% lower than the index level on January 1, 2014. Thus, it is no surprise that those analysts who use PE ratios based on average earnings over time come to the conclusion that stocks are over priced.

 Growth Rates

The use of analyst estimates of growth can make some of you uneasy, since analysts can sometimes get caught up in the mood of the moment and share in the "irrational exuberance" of the market. While using top down estimates (as opposed to the estimates of growth in earnings for individual companies), provides some insulation, there is a secondary test that we can use to judge the sustainability of the predicted growth rate. In particular, when the return on equity is stable, the expected growth in earnings is a product of the retention ratio (1- payout ratio) and the return on equity:

Sustainable growth rate = (1 - Payout ratio) (Return on equity)

Using the 84.13% payout ratio and the return on equity of 15.790% generated by the market in 2013, we estimate an expected growth rate in earnings of 2.67%, lower than the analyst estimate of 4.28%. Substituting in this growth rate lowers the value of the index to 1741, making it over valued by about 6%, at its current level.

Book Values

All that said , when one takes a look at book values , one will come to a different conclusion . With the median 

over twenty years 2.75 , still we are below this level at 2.65 in the USA  .In Japan , historical 1.07 , current 1.04 & finally  India ; historical 3.45 , current 2.6 .Plenty of room for upside ,one would feel. Especially as bond rates are still well behind historical norms.

Conclusion 

We are now at the point where caution should be intertwined with investing .But , still retain our bullish focus for the long term .

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   and may your Prophet go with you