Part 2 – Lesson 10

### Overview

At the end of Part 2, Lesson 9, we discussed the idea of becoming familiar with historic multiples as an investor gains experience covering certain industries and companies.  In this lesson, we will evaluate the historic P/E multiple of the S&P 500.  Knowing the valuation of the S&P 500 at any given point in time is very important.  It gives you a sense for when the market is generally trading at low valuations or very high valuations.  It provides investors with context.

If the S&P 500 is trading at 15x forward earnings, for example, many investors will use this as a benchmark for the “average” valuation of the overall stock market.  This provides context for how expensive or cheap a company’s stock is relative to the market.  A stock trading at 10x forward earnings would be trading at a discount to the market vs. a stock trading at 20x forward earnings would be trading at a premium to the market.

Let’s review a few terms before diving deeper into the S&P multiple:

1. Next Twelve Month (NTM) Earnings – The S&P 500 P/E ratio is typically calculated on forward earnings. “Forward earnings” generally refers to earnings in some future period.  For the S&P 500, most investors look forward to the next twelve months’ of earnings in calculating the E in the P/E ratio.  Currently, the month is July 2018.  Thus, the NTM earnings would be July 2018 to June 2019.  Since most analysts do not estimate monthly earnings for the S&P 500 (or any stock for that matter), investors can estimate NTM earnings by taking 50% of 2018 earnings and 50% of 2019 earnings.

2. Last Twelve Month (LTM) Earnings – Many investors also evaluate the S&P 500 based on last twelve month earnings. The importance of LTM earnings is that is shows what the S&P 500 has actually earned in the LTM period.  Since forward earnings estimates are simply estimates (which are subject to change), the LTM earnings provides a concrete E with which to calculate P/E.  Additionally, for investors looking to plot historic P/E ratios over many decades, historic LTM earnings data tends to be more readily available vs. historic forward earnings.

3. Historic Forward Earnings – When an investor analyzes historic forward (NTM) earnings, this data incorporates what the NTM earnings were in the past. This gives investors a sense for how the market was being valued on a forward basis at a certain point in the past.  For example, to make a judgment on the valuation of the S&P in June 2008 (prior to the financial crisis), you need to know the level of NTM earnings of the S&P 500 in June 2008.  In other words, what did analysts estimate for June 2008 to May 2009 S&P earnings in June 2008?  This gives investors a good sense for the forward P/E ratio just prior to the 2008 recession.

### S&P 500 Earnings

The S&P 500 is an index, maintained by S&P Global.  The index contains 500 of the largest companies in the United States.  S&P calculated the price of the index by adding together the market caps of all 500 companies and then dividing it by a “divisor” that is proprietary to S&P.  While this divisor is proprietary, it can essentially be thought of as the total shares outstanding for all 500 companies in the index.

Similarly, the EPS for the S&P 500 is calculated by summing the net income of all 500 components and then dividing it by the same divisor used to calculate the S&P price level:

S&P 500 EPS = Sum of Net Income of all 500 Components / S&P’s Divisor

To find the earnings estimates for the S&P 500, Factset is a reliable data source.  As of July 2018, Factset publishes a weekly report that details the latest earnings estimates for the S&P 500.  Below is a snapshot of Factset’s Earnings Insight report from July 6, 2018:

The above chart shows the yearly EPS for the S&P 500 over the last 10+ years.  You can see the large dip in EPS in 2009 due to the 2008 financial crisis.  You can also a big jump in S&P earnings in 2017 and big expected jumps in EPS in 2018 and 2019 (the grey bars are earnings estimates whereas the dark blue are actuals).  The big jump in EPS estimates for 2018 and 2019 is due to the reduction in the corporate tax rate to 21% from 40%, which created large tax savings for S&P 500 companies.  Additionally, an overall positive economic climate has provided a supportive backdrop for earnings growth.

Historically, the S&P 500 index (as well as the underlying components) will follow earnings.  As earnings estimates go up, the price of the S&P 500 increases in anticipation of higher earnings, and as earnings estimates go down, the price of the S&P 500 decreases in anticipation of lower earnings.  This is the holy grail of what drives markets higher or lower: corporate earnings.

Here is a good example from the same Factset report, showing the 10-year historic trend of the S&P 500 price vs. its underlying earnings:

The light blue line is the S&P index, which you can see generally follows the direction in which the underlying earnings estimates are headed (dark blue line).

### Calculating the S&P 500 P/E Multiple

Let’s now calculate the P/E ratio of the S&P 500 using the EPS estimates from Factset:

Dividing the current S&P 500 index level of 2,800 by the NTM EPS estimate of \$168.95 yields a forward P/E ratio of 16.6x for the S&P 500.  How does this 16.6x P/E ratio compare to historic valuations?  This is the key question to understanding how expensive or cheap a market is trading today.  Below is a chart from the Factset Earnings Insight report from July 6, 2018:

The above chart shows 10 years of the historic forward P/E ratio of the S&P 500.  You can see that the forward P/E ratio bottomed at 9x earnings in the heart of the 2008-2009 recession.  In the years since the 2008 financial crisis, the highest S&P valuation reached was around 18.5x in 2017.  Additionally, Factset is calculating that the 5-year average forward P/E ratio is 16.2x, while the 10-year average P/E ratio is 14.4x.

It is a good idea to commit these trading ranges to memory.  Knowing that the S&P has historically traded in the range of 9x to 18.5x provides a general range to judge how expensive or inexpensive the market currently is.  With the S&P current’s valuation of 16.6x, the S&P 500 is trading towards the high-end of its historic range.  This data can also be helpful in identifying when the S&P is trading at extremes.  During the internet bubble, the S&P 500 traded well north of 20x earnings, which turned out to be dangerous time to invest in hindsight.

It is also important to remember that valuations don’t provide insight into market timing.  Just because the S&P is trading at an expensive valuation, does not mean that the S&P will go down.  And just because the S&P is trading at a cheap valuation, does not mean the S&P will go up.