Driving Shareholder Value

S&P Index Still Undervalued

2011-01-14T12:20:00.000-05:00

Despite overvaluation concerns, the rise in the S&P 500 Index appears to be earnings driven and not speculative. The RPF Model shows that the S&P 500 is undervalued by about 7%, narrowing from the 30% undervaluation estimate that I reported in my September 28, 2010 articleand the 20% that I reported on November 8, 2010. This suggests continued opportunities for investors, corporate buybacks, and M&A.

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Strategists Lowball 2011 Projections for S&P 500

2011-01-14T12:18:00.000-05:00

A number of strategists at major brokerages have issued outlooks for earnings and the expected level of the S&P 500 Index (SPY) at end of 2011. Based on their earnings projections and current long-term Treasury yields they all could be underestimating the index before the end of 2011.

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Debunking the Myth of Infinite Online Advertising Inventory

2010-11-15T13:28:00.000-05:00

Advertisers are not seeking impressions as much as the opportunity to get a slice of audience time to communicate their message. Resolving the inefficiency of paying per impression while seeking time would provide upside to premium online publishers.

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The Market Is Up, But So Are Earnings – S&P 500 Still Appears Undervalued

2010-11-08T09:33:00.000-05:00

Some have voiced concern over the market reaching its highest levels since Lehman’s collapse, but the steep rise appears to be earnings driven and not speculative. The RPF Model shows that the S&P 500 is undervalued by about 20%, narrowing from the 30% undervaluation estimate that I reported in my September 28, 2010 article. This suggests opportunities for investors, corporate buybacks, and M&A.

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Post-Earnings Analysis: Google Now Expected to Grow Faster Than Apple

2010-11-04T14:19:00.000-04:00

Real Implied Growth Rate (RIGR) shows market expectations for long-term growth in earnings implied in an individual firm’s stock price. RIGR analysis shows growth expectations for Google (Nasdaq: GOOG) rose while Apple (Nasdaq: AAPL) was unchanged following earnings release. Google is now expected to grow faster than Apple.
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Market Expectations for Apple, Google and Yahoo Using Real Implied Growth Rate

2010-11-04T14:17:00.000-04:00

Real Implied Growth Rate (RIGR) shows market expectations for long-term growth in earnings implied in an individual firm’s stock price. RIGR analysis shows growth expectations for both Google (Nasdaq: GOOG) and Apple (Nasdaq: APPL) are in the upper 60thpercentile for S&P 500 companies…closer to the middle than the top.

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Real Implied Growth Rate: Understanding Market Expectations

2010-10-12T17:12:00.000-04:00

Real Implied Growth Rate (RIGR) reveals market expectations for long-term earnings growth implied in an individual firm’s stock price. Comparing RIGR for a single firm to the overall market and its industry can help investors identify over and undervalued firms and sectors. This analysis reveals dismal growth expectations for Microsoft (Nasdaq: MSFT) with an expected long-term decline putting Microsoft in the bottom 11% of S&P 500 companies. Is that reasonable?

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Technology on the Horizon: What if Moore’s Law Continues for Another 40 Years?

2010-10-07T09:45:00.002-04:00

Moore’s law says that computer power doubles for the same cost about every two years, implying rapidly falling cost, increased power and proliferation. If this continues, the equivalent price of a $600 iPhone would be $18.75 in 2020, $0.59 in 2030 and overall power or cost improving 1,000,000 times by 2050. How should we account for this possible scenario in our investment strategies and plan for potential impact? What products and services have good present potential but could be enormous if Moore’s law continues?

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Companies Mentioned: AMD / AMZN / DELL / GOOG / HPQ / INTC / MOT / ORCL

Mobile Apps: The Wave of the Past

2010-09-29T11:37:00.000-04:00

Mobile today is like the Internet in the 90's with relatively slow connections and limited browser capability. Just like the PC Web, improvements in mobile Web will bring down today's walled gardens.

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Companies mentioned:

AAPL / AOL / CMCSA / GOOG / MSFT / NWS / NYT / RIMM / SERV / TWX/ YHOO

Why Internet Won’t Kill the Video Sub - Seeking Alpha

2010-09-20T10:15:00.000-04:00

Social media helps extend live-worthy programming beyond sports, news and weather - stemming the time-shifting tide by making live viewing a richer experience than time-shifted.

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Companies mentioned: NYSE: T, NYSE: CVC, NASDAQ: CMCSA, ASDAQ: DTV, NASDAQ: DISH, NYSE: TWC, NYSE: VZ, NWS, DIS

Dumb Money and Bubbles

2010-09-09T13:10:00.000-04:00

We keep reading about how funds are flowing out of mutual funds and into bonds.

“In Striking Shift, Small Investors Flee Stock Market” – New York Times, August 21, 2010

Much of the commentary suggests that this lack of confidence is a sign of further trouble ahead for equities. In fact, the research indicates the opposite. “Dumb money: Mutual fund flows and the cross-section of stock returns” a 2006 paper by Adrea Frazzini (University of Chicago) and Owen A. Lamont (Yale), if not obvious from the title, concludes that money flow is a contra-indicator. Excess money flowing in, raises price and leads to an eventual market decline, while money flowing out tends to presage a rally. They put it simply:

“Our main result is that on average, retail investors direct their money to funds which invest in stocks that have low future returns. To achieve high returns, it is best to do the opposite of these investors... We call this predictability the “dumb money” effect.”

A similar sentiment was expressed by Joan Lemming of Gramercy Capital in Forbes, “Bond Lemmings Headed for the Cliff”. She compares the 2000 tech bubble to today’s bond market and points out that the flows into bond funds “dwarf whatever led to the bubble in 2000 by a long shot.”

So today we have the “dumb money” flowing out of equity funds and into bond funds. All this supports that the predicted values from my RPF Valuation Model and the thesis of my last post, “Bond Bubble or Inverse Bubble,” that equities are undervalued and bonds overvalued.

2000 “Dot Com” Bubble: RPF Valuation Model Suggests Significant Bubble for the S&P 500

2009-07-23T14:08:00.008-04:00

The NASDAQ peaked on March 10, 2000 at 5,132 in what is widely considered to be a bubble driven by excessive valuations of Internet and other technology companies. Many economists such as Robert Schiller, author of Irrational Exuberance, believed that the entire market was embroiled in a speculative bubble throughout this period[i]. Application of the RPF Valuation Model to the S&P 500, strongly suggests that a significant bubble did exist.

Looking at the period from 1986 – mid-2009, the dot.com bubble appears as the greatest and most enduring bubble of the entire period:

Prior to the fall, 10 Year Treasury yields increased from 4.6% in November 1998 to 6.2% in March 2000. While the NASDAQ began to run up in late 1999, the S&P 500 Index began to diverge from predicted (using the RPF Valuation Model) in January 1999.

The predicted and actual index levels again reached parity in February 2002. This appears to be a largely interest rate driven event. The chart below shows the same time period, but with 10 Year Treasury yield held constant at 4.75% - the rate in November 1998, before the bubble began to form – as the input for the RPF Model in the “predicted” line in the chart below.

For more on underlying assumptions behind the calculations please see "The Risk Premium Factor: A New Model for Understanding the Volatile forces that Drive Stock Prices" (Wiley Finance) available on Amazon. (http://amzn.to/jRHEAe )

[i] Robert J. Schiller, Irrational Exuberance, (Princeton University Press)

How The RPF Model Explains 2008 - Up to Meltdown

2009-05-31T13:51:00.007-04:00

The bursting housing bubble and mortgage crisis ultimately led to the meltdown that began September 2008. By August 2008 the S&P 500 had already fallen by 16% from its May 2007 peak. During this period 10 Year Treasury yields declined from around 5% to less than 4%. As illustrated in the chart below, this led to an increase in predicted levels of the S&P 500 index.

According to the Case-Schiller Home Price Index, home prices fell more than 10% from second quarter of 2006 to the fourth quarter of 2007 and a total of 18% by the second quarter of 2008 . This historically large decline led to (well founded) concerns of financial instability and eliminated an important source of disposable income. Once again, in anticipation of a decline in earnings, the S&P 500 index fell while the RPF Model (using reported operating earnings) showed an increase in predicted levels as interest rates declined. The two lines begin to converge in August 2008, just before the worst of meltdown began in September and October.

For more on underlying assumptions behind the calculations please see "The Risk Premium Factor: A New Model for Understanding the Volatile forces that Drive Stock Prices" (Wiley Finance) available on Amazon. (http://amzn.to/jRHEAe )

How the RPF Model Explains October 19, 1987 (Black Monday)

2009-04-22T20:25:00.008-04:00

U.S. and Global markets plunged on October 19, 1987 with the S&P 500 declining more than 20%. The cause of the decline has been much discussed with program trading often cited as the main culprit along with portfolio insurance (derivatives).

The application of the RPF Valuation Model to this period is very revealing. The chart below shows actual versus predicted S&P levels:

This second chart shows actual versus predicted PE Ratios, along with Treasury yields:

For more on underlying assumptions behind the calculations please see "The Risk Premium Factor: A New Model for Understanding the Volatile forces that Drive Stock Prices" (Wiley Finance) available on Amazon. (http://amzn.to/jRHEAe )

Abstract

2009-04-14T20:57:00.009-04:00

Driving increases in shareholder value is one of the most important responsibilities of any business leader, but many are handicapped by not having a deep understanding of what drives value. Factors that drive value are easily understood using a simple constant growth equation: P = E / (C – G). When combined with a new approach for estimating the Market Risk Premium, called the Risk Premium Factor, current risk free rate and some simplifying assumptions, the Risk Premium Factor Model explains S&P Index levels with good accuracy for 1960 - present.

The RPF valuation model is P = E / ((R_f x (1+RPF) – (R_f - Int_R+ G_R)), where

R_f= 10 Year Treasury yield

E = S&P 500 operating earnings

Int_R = Long-term real interest rates derived from TIPS yields

G_R= Long-term real growth rate for the Earnings assumed to be long-term GDP growth

RPF = Risk Premium Factor Constant

Results for 1960 – 2008 are shown below:

This tells that only three things matter:

Earnings
Growth
Interest rates which drive cost of capital and embody inflation.

Introduction

2009-04-14T20:07:00.005-04:00

Driving increases in shareholder value is one of the most important responsibilities of any business leader, but many are handicapped by not having a deep understanding of what actually drives value. Understanding valuation is central to being able to develop strategies and make day-to-day decisions that increase shareholder value.

Some people see the stock market as arbitrary and sometimes random in determining value. For the most part, I believe the market is very efficient in incorporating available information to value a company’s shares. Certainly problems with liquidity and other factors can knock valuations out of line for a period of time, but over a longer horizon, not only is the market is efficient, but valuations are easy to explain.

The factors that drive the overall market are actually simple and easy to understand. Through this paper, I will explain those factors. This includes what I believe to be a new and original approach (of my own invention) that combines generally accepted approaches to valuation with a simple but new approach to estimating the Equity or Market Risk Premium (MRP) that produces very good explanations of market P/E ratios and overall market levels. The chart below shows how the Predicted P/E when applied to S&P Operating Earnings explains levels of the S&P 500 over the past 48 years.

My approach to estimating the Market Risk Premium is the most original part of my overall hypothesis. (I have not found any similar approaches through my research, so please let me know if you have seen similar applications.) Many, if not most theorists, assumed the Market Risk Premium was a constant based on historical premiums above the risk free rate. Using the constant earnings growth model (see Constant Growth Model), I plotted P/Es where:

Predicted P/E = 1/ (Cost of capital – Real Growth – Inflation)

Where:

Cost of capital = Risk Free Rate + Market Risk Premium

There seemed to be no relation between predicted and actual PE, while using any range of risk premium constants.

I suggest that that the Market Risk Premium is not a static number but a variable that fluctuates in direct proportion to the long-term risk free rate. The central idea is that the risk premium is fixed as a percentage of the risk free rate, not a fixed premium. Regression analysis showed that when applied to the constant growth model, cost of capital could be determined by the following formula for 1982 - 2002:

Market Risk Premium = Risk Free Long-Term Rate x Risk Premium Factor (0.75)

Intuitively, this seems to make sense. Conventional theory would hold that if the Market Risk Premium constant were 6.0% and 10 year treasury’s were 4.0% then investors would expect equities to yield 10%, but if 10 year Treasury yields were 10% then investors would seem to require a proportionately smaller premium with a 14% return. I propose that using this MRP factor, investors would only expect equities to yield 7.0% when Treasury yields were at 4.0% and 17.5% when they were at 10%, the same proportionate compensation for risk.

This Risk Premium Factor (RPF) seems to hold steady for long periods of time, changing just twice from 1960 – present (April 2009). The RPF was 1.22 from 1960 -1980, 0.75 from 1981 – June 2001 and 1.46 from July 2002 – present. As shown above, the market does a very good job of predicting market levels. The model holds nicely through the present and, assuming that 10 Year Treasury yields are artificially low with the current flight to quality, even through the current financial crisis. Yields have been 2.2%-2.7% over the past few months (ending March 2008), compared to a range of 4.1% to 5.1% in 2006 and 2007 and rarely falling below 4% since 1960.