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The Globe and Mail

Valuing the S&P 500 as a business: priced for perfection

American flags fly outside the New York Stock Exchange on Oct. 14, 2016.

Michael Nagle/Bloomberg

U.S. equity markets are trading within a couple of percentage points of their record highs, so it is not surprising that there has been a flurry of articles on whether the market is overvalued. Few of them, however, look at the market index as a business in which you might invest, and at what price.

This is surprising because investors are often encouraged to view a potential investment as if they were buying the whole company rather than a few hundred shares. If you know that you cannot sell instantly, you are more likely to adopt a long-term viewpoint on the profitability of the business and the cost of an investment in this earnings stream.

For example, would you pay three times book value to buy the net assets (shareholders' equity) of a company that reported annual revenue growth of only 3.2 per cent since 2004? What if you also knew that the company's return on its equity had averaged 12.6 per cent over the same time frame? At three times book value, the earnings yield on your investment will be only 4.2 per cent, half of it in cash. This is an aggressive valuation even in the current interest rate environment. I suspect that you would want some assurance that these levels of growth and profitability can be sustained or improved upon.

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These are the valuation parameters you face today if you buy an ETF or index fund based on the S&P 500 index, which represents a broad-based exposure to the U.S. equity market.

So, are the underlying businesses of the S&P 500 index an attractive proposition at the current valuation? The statistics to tackle this question were extracted from the website. Data for the 12 years ending March 31, 2016, include book value per share, trailing 12-month earnings per share and sales per share.

Looking back over the past 12 years takes us through the financial meltdown of 2008-09, so the numbers take a hit during that period, but the full time frame since March, 2004, includes a healthy recovery in recent years. Book value per share for the index has grown at a 5.9-per-cent annual rate, earnings per share have grown more slowly at 4.3 per cent a year, while sales per share have lagged at 3.2 per cent annually. Earnings and book value have grown more rapidly than sales probably as a result of a wave of share buybacks, which has shrunk the number of shares outstanding even as sales have stagnated. Recent reports suggest that this source of earnings enhancement is losing momentum.

A company can also improve earnings through cost control and improved productivity, but in the absence of revenue growth there is a limit to this strategy. Corporate America may be reaching that limit. Sales growth for the full 12-year period was already modest at 3.2 per cent a year. For the most recent five years, it has been a paltry 0.5 per cent and sales per share are actually down 5.3 per cent from the peak in December, 2013.

The recent slowdown in revenue growth may reflect the strength of the U.S. dollar in converting the overseas currencies of the multinationals that dominate the index. Setting aside the exchange-rate effect, most countries today would be delighted if their economy grew at a 2 to 3 per cent annual rate. As a result, this may be a reasonable expectation for revenue growth for the S&P 500 companies. If so, we are paying three times book value for a business where sales, earnings and dividends are likely to grow in the 2- to 3-per-cent range at best. A steep entry price unless the profitability of those sales is extraordinarily high.

Measuring the market's profitability in terms of return on equity, the average of about 13 per cent has been quite stable over the last 12 years except for the write-offs in 2009. Using 13 per cent as a forecast, the recent book value per share of $752.77 will generate sustainable earnings per share of $98. This isn't a forecast for any particular period, but an indication of the earning power of the index based on historical profitability. The S&P 500 index at present trades at 2140 – 22 times sustainable earnings.

Now for a reality check: the only way an investor can justify paying 22 times earnings for a 3-per-cent growth business is if the expected return on investment is about 5.5 per cent.

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My initial reaction is that a return of 5.5 per cent is below the expectations of most investors in the equity market, although in fact it may be realistic. The real return, after inflation, on common stocks has generally been calculated at 6 per cent annually over the long term.

If inflation remains close to zero, then the expected return of 5.5 per cent built into the S&P 500 at current prices is in line with history and the market is fairly valued but certainly not cheap.

There is no margin for error. Central banks would like to see inflation closer to 2 per cent than zero, few countries around the world are growing sustainably at 3 per cent or better and investors may decide that investing in the stock market requires a higher expected return to compensate for political risk. Any of these factors would be a serious negative for the U.S. equity market. A small increase in required return leads to a significant decline in price-earnings ratios.

It is possible that corporate America will extract a larger slice of the global economy and enjoy accelerating revenue growth over the next few years, which would support a higher market valuation. Based on recent trends, however, investors in the S&P 500 would be smart to keep one eye on the exit door.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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