Sunday, November 2, 2008

3Q08 Earnings Season and Valuation

What a week. We wrap up the worst month in the market since the 1987 crash by enjoying the best week in the market in 34 years. This neurotic bi-polar market continues to redefine everyone's view of volatility. It feels like we've had 3 years worth of action in just the past few weeks. The news flow has been incredible as well as the financial crisis continues to unfold at the same time as earnings season is in full swing.

Now that I've had a chance to catch my breath, there are a few thoughts about this earnings season that I thought I'd share as we enter the last heavy week of reporting. First of all, it isn't surprising that most of the news on the earnings front has been rather disappointing this quarter. It's looking like earnings for the quarter may end up falling 9-10%. Few firms in any industry are very upbeat about the near future although most firms claim to be very well-positioned for the long-term. This is just how things are done during a "slowdown." Mangements are typically of the optimistic sort, so when the near-term outlook is terrible, the conversation begins to focus more on the long-term, for which their enthusiasm knows no bounds. Of course, when the near-term starts to improve, we can expect the conversation to quickly shift back to their more typical, "long-term", three-month outlook.

Another point that I'd like to stress is that it gets a little more difficult during an economic downturn to assess the performance and prospects of a firm. Whatever the true reason for a slowdown in sales, a fall in margins, or a lower earnings forecast, virtually all companies will blame any shortfall on the economy. Thus, differentiating between company-specific and economy-specific reasons for a firm's poor performance gets a little tricky. No CEO really wants to say, "Hey. Not only does the economy stink, but we've been really making a mess of things around here ourselves." So, instead, blame gets shifted solely to the economy. For this reason, paying attention to a company's industry peers takes on even more importance during a recession (yes, this is a recession). If all of the companies in an industry are hurting fairly equally, it's probably the economy. The larger the differences in performance, the less likely it is that the economy is the only factor impacting the laggards.

Finally, let's take a look at earnings expectations for the fourth quarter and 2009. A report from Thomson Reuters Research came out in the middle of last week that showed that analysts were expecting earnings for the fourth quarter to increase by 32.2% and for 2009 to show growth of 15.7%. I suppose anything is possible, but these figures strike me as a touch absurd.

Let's look at earnings estimates a little closer, using Standard & Poor's data. For the fourth quarter of 2008, the estimate for S&P 500 earnings based on analyst projections (bottom-up) is calling for a 15.2% sequential increase over Q3 and a 36.8% increase year-over-year. These are operating earnings, which leave out all of the "one-time" items. Unfortunately, there isn't a comparable top-down operating number. The top-down estimates that we have come from strategists (as opposed to analysts) and are for reported earnings, which do include those "one-time" items.
It's interesting to note the difference in these figures. The bottom-up (analyst) operating estimate for the fourth quarter stands at $20.82 while the top down (strategist) reported figure comes in at $12.12, 42% lower. For 2009 those numbers are $94.25 and $48.52, respectively. That's a huge difference of 48.5%. By way of comparison, the difference between the reported and operating numbers for 2007 and 2006 were 19.8% and 7.1%, respectively. The difference for 2008 is forecast to be 25% currently.

What does this mean for valuation? The S&P 500 index closed last week at 968.75. Put a 15 multiple (arbitrary) on the $94.25 figure for 2009, and you get a level for the S&P 500 o
f 1413, implying that the market is undervalued by 45% currently. Put that 15 P/E on the $48.52 figure, however, and we find fair value at 727, implying the market is overvalued still by 25%.

There are two points to this analysis. First of all, the bottom-up estimates from the analysts are almost always too optimistic, particularly during a downturn. The analysts are being spoon-fed by optimistic managements and are therefore very slow to bring their numbers down to better reflect reality.

The other point is that we have to be very careful when trying to value the market using P/E analysis. There are a number of different earnings measures and time frames that can be used. The use of a particular P/E multiple is also highly subjective. Care must be taken not to mix a forward (2009) earnings estimate with a P/E based on historical trailing earnings. Forward P/Es must be applied to forward earnings, and trailing P/Es must be applied to trailing earnings. Better yet, these inputs should be normalized for the business cycle. Unfortunately, rather than approach valuation objectively, many people tend to use the combination of earnings and multiple that best helps them justify the bullish or bearish view they already hold. This is called data mining, and it's a dangerous substitute for objective analysis.

Disclosure: The Rubbernecker is long mining, but not data mining.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.