Davidson”: S&P Fair Value 1420


“Davidson” submits:

This commentary introduces the concept of the SP500 Total Shareholder Return Index to contrast the SP500 Earnings Trend Index (formally SP500 Investor Value Index). The reason for adding another index is simple. Market thinking the past 200yrs or so has focused on Net Income as the return to shareholders, but this is not the full picture of corporate performance as far as shareholder returns.

Shareholders receive only 2-streams of returns, i.e. Dividends and Growth in Corporate Assets or BV/Shr. As a shareholder one does not actually receive a payment that represents the growth of the corporation because it is reinvested for future growth. In some instances, management makes poor decisions and the amount reinvested is offset with inventory write-downs or charge-offs thus causing BV/Shr to fall. Another management action which results in less growth in BV/Shr than that which could otherwise be is share buybacks.

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Share buybacks have, for as long as I have been in this industry, been touted as beneficial to shareholders. They are thought as a return of cash to shareholders and a substitution for dividends. Nothing could be further from the actual effect. Share buybacks use corporate cash very often to buyback stock at elevated Price/Book Value ratios which cause an immediate loss of return to shareholders than what would have been had the cash not been spent. Buy backs have received wide spread support since a securities’ law change in 1983. Buy backs have accelerated from ~4% of Net Income to over 40% of net Income since. This causes companies to grow at a slower rate than the Net Income that they are earning during economic uptrends when buy backs are most active.

Not seeing this effect, the market’s sole focus is Net Income. Buy backs are detrimental to shareholder returns!!

Thus the SP500 has 2 valuation indices below:

SP500 Earnings Trend Index-Tracks the historical support the market has given to SP500 Earnings over time
SP500 Total Shareholder Return Index-Tracks the actual returns that shareholders receive over time-Dividends and BV/Shr Growth

It is my opinion that the market’s love affair with Net Income leads to many misperceptions. The acceptance of share buybacks is one of these. There are many others too numerous to mention here, but they do not have factual support when one examines the how markets are priced over the long term and can identify the fundamental inputs.

One can see that the (dashed line) representing the SP500 Total Shareholder Return Index has lagged behind the SP500 Earnings Trend Index (solid line) from 2000 on due to heavy share buyback activity. The period of 2006 thru 2008 was a period of greater asset growth as a commodity bubble developed and this trend reversed till 2009 when buybacks accelerated.

Using the SP500 Total Shareholder Return Index provides a lower fair value for the SP500 based on the current core inflation readings and Real GDP growth rate assumptions. Even so, the SP500 remains undervalued by more than 18% which places fair value at ~$1420.

H/T to Value Plays

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