There seems to be a lot of disagreement around what stocks are worth and what the various index levels “should” be. This debate is reaching a high volume of late due to the uncertainties present. How high will inflation go? How long will it last? What will the Fed do with rates? Can inflation be tamed? Will the economy head into a recession? What will happen to corporate earnings?

Against this backdrop of uncertainty, stocks are down while bonds are having their worst year EVER (well since around the time the new United States of America began selling bonds just after it was formed.) With the heightened volatility and negative returns, people want to know: how far can this go? When will it be over?

There is a rational framework available to help answer the question: what are stocks worth?

This framework is called the Gordon Growth Model (GGM). The formula itself is simple—especially when modified from its original design of modeling dividends and converted to modeling earnings. The magic in getting an informative answer from this model is more about thoughtful and accurate inputs. The notion of “garbage in, garbage out” (so called GIGO) is apropos. Understanding the dynamics involved inside the economy and capital markets is essential to gaining some valuable perspective from the model. Without further ado, here’s the original GGM for dividends:

P= D1 / k-g

P = Stock Price today
D1 = The dividend in the current period
K = The required rate of return, and
G= The constant growth rate of the dividend

 

Through algebraic derivation, the above formula can be modified from discounting dividends in perpetuity to discounting earnings in perpetuity. The formula becomes:

P=EPS1 / k

P = Stock Prices today
EPS1 = The earnings in the current period
K = The required rate of return

 

So, there it is! This is an extremely simple formula. The magic comes not so much from its form (although its simplicity is beautiful and it is theoretically robust), but from the thinking used to develop thoughtful and fully informed inputs. The magic of this model lies in the INPUTS. Hence the modeler’s thinking and justification for the inputs is critical.

The required rate of return for a stock equals the risk-free rate plus the equity risk premium. At its core, the equity risk premium is an estimate and as such many people can calculate this value with slightly different methods which can result in different estimates of asset value.

Please note that for our purposes, “Risk-Free” is the equivalent of a 90 day Treasury Bond, which just means that “risk-free” means that the note’s principal is guaranteed by the full, faith and credit of the United States Government.

To understand how this model works, let’s turn back the clock to January 1, 2022. At that time, the stock market was at an all time high, inflation was widely considered transitory, interest rates were near zero, and corporate earnings were growing rapidly with expectations for continuing high economic growth. So, let’s work with those January 1, 2022, prevailing conditions and see what insights into stock market levels might be revealed.

On January 1, 12 month forward corporate earnings for the S&P 500 Index companies were expected to come in at $220. The risk-free rate was basically 0-25 basis points, and the equity risk premium probably was at the lowest end of its historical norm at 4.5%. Plugging these values into the modified GGM:

$220 / 4.75% = 4632

This estimated value of 4632 is eerily close to the actual S&P value on December 31, 2021, of 4766. In fact, the S&P traded down to the 4600 level in a few trading sessions after January first of this year. So, the market was basically pricing in perfection on January 1, 2022.

The important questions revolve around what the reasonable long-term equilibrium levels are for: 1) the risk-free rate, 2) the risk premium for stocks, and 3) the inflation rate. On top of this, we need to figure out what corporate earnings expectations are for 2023, because estimates are coming down now.

Suppose we now think the long-term risk-free rate is 4% (owing to inflation). Suppose further we think the risk premium for stocks is now higher say 8%, meaning we require stocks to pay us more due to economic uncertainty and higher inflation. If 2023 earnings do not come in at the $250 level expected earlier this year but instead come in at $220, then what does our model say? Warning: Brace yourself!

$220 / 4%+8%=1833

This simple exercise tells us why the market is down this year. Inflation is raging, interest rates are rapidly rising, and earnings are under pressure. There could very well be additional downside in stocks from where we are today as the reality of these forces comes to bear. We should not, however, expect the market to drop to this 1800 level…. but it could. If it did, this would be a SCREAMING BUY! (The P/E multiple would be a shocking 9, which is not likely).

Readers should note here that the notion of these types of market changes occurring to correct previous market changes, like an elastic band snapping back, are not guaranteed, and investors should be aware of the possibility that such large price movements may have a “snap-back” corollary. You should always be ready for anything in the market.

What we really want to answer is: “where might the market be in long-term equilibrium after this current episode is over and in the rear-view mirror?” Let’s assume we begin the year 2028 under the following conditions: 1) inflation is under control at 2%, 2) corporate earnings are fully recovered, strong and growing with expected twelve-month forward earnings at $350, and the risk premium for stocks is now 5%. Under this scenario, the S&P 500 level will be:

$350 / 2%+5%=5000

If these are the conditions that prevail at the end of 2027, the S&P should be trading somewhere around 5000. The question is, can you live with that? If the S&P goes from 3600 today to 5000 at the end of 2027, can you live with that? Most investors can. If that is our 5-year bogey, set your sights on that. If stocks go “on sale” from here, be confident that you are improving your expected return by buying more at those lower levels. Also, a level of 5000 would represent a very reasonable P/E ratio of 15. If the P/E were to be 20 (which is quite possible), then we are looking at an S&P level of 7000, which all investors can live with…nearly a double from where we are today.

What are the lessons learned from this episode? First use this model framework to take the emotion out of your decisions. Second, extend your horizon and look down the road. You will find that the short term drops and volatility conditions we are dealing with are totally manageable. Look down the road and trust the process. Thank you for your business and do not hesitate to contact your advisor for further perspective.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed. No investment strategy can assure success or completely protect against loss, given the volatility of all securities markets. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. All performance referenced is historical and is no guarantee of future results. Securities investing involves risk, including loss of principal. An investor cannot invest directly in an index.

Advisory services offered through WealthPlan Investment Management, a subsidiary Registered Investment Advisor of WealthPlan Group, LLC.