Financial Stocks & Dilution

Since the financial nightmare of late 2008, financial institutions have engaged in various capital raising ventures. Included in this is an increase in the number of common shares outstanding. Please remember this when bidding up the shares: market capitalization is the product of share price and shares outstanding !!!!!!!!!

For example:

Bank of America

Average common shares issued & outstanding Q2 2009: 6.81 billion


Average common shares issued & outstanding Q2 2008: 4.43 billion

Therefore, today's close of $15.64 per share of common stock is roughly equivalent to a price of $24.04 from 1 year ago (keeping market cap constant).

Not something we are accustomed to thinking about.....

S&P 500 Earnings

http://www.bloomberg.com/apps/news?pid=20601087&sid=aUbVti8SvAMA

Surging Profit Estimates Signal 26% Rally for S&P 500

In the above linked article, the authors state that "Wall Street firms estimate the S&P 500 will earn $74.55 a share next year." They neglect to mention that this is on an OPERATING basis. It does not include items that are not perceived to be parts of everyday business, e.g. write-offs.

In my posts regarding equity valuation, I have been relying on S&P's own estimate of AS REPORTED earnings. My reasoning is that these write-offs have been so pervasive and consequential, that ignoring them would vastly overstate future earnings potential.

For calendar 2010, S&P estimates operating earnings of $74.01, not too far from the Street consensus. However, their as reported number comes in at $37.26. That is basically one-half of operating earnings. The below graph tracks the ratio of the reporting methods. You be the judge. (Note: my analysis consistently tracks historical as reported numbers, I NEVER combine apples & oranges.)

Equity Market Valuation

Having now entered the 2nd quarter earnings season (37 of the S&P 500 companies have reported so far), it seems like the right time to review valuations:

S & P 500 closed at 954.58 yesterday

My fair value opinion: 726.97

The index needs to drop 23.84% to compel me to buy.

At 726.97, the earnings yield would equal the long term average of 4.795%

The earnings yield at current levels is 3.652%.

The earnings yield calculations are based on 2010 numbers: using S & P's forecasts, I arrived at a figure of $34.86.

Dow Jones Industrial Average 2009

...where it stops, nobody knows.

Based upon revised earnings estimates, I think fair value for the DJIA is 6,882 (drop of 19.1% from today's close). I backed into this number by taking my estimate for the S&P 500 and multiplying that by the the 200 day moving average of their ratio: 723.63 * 9.51

At this point, neither equity index is screaming over bought nor over sold. This will be a tricky couple of trading sessions until the FOMC meeting on the 24th (2 day meeting).

S&P 500 Earnings Review

With 492 of the S&P 500 members reporting, it looks like 1st quarter earnings will total $7.59 (as reported, no operating earnings nonsense). The trailing 12 month tally will be $6.93, a far cry from the high set in June of 2007: $84.92 (yep!).

Valuation is, quite frankly, on another planet. It is possible that the recession is over and this is a bull market. However, there is little caution being exercised by market participants. Protective put buying is low and the market is overvalued by almost 27% in my opinion. To pay 27% more than historical valuations tells me that a bull market is a certainty. How can anyone be that sure of a profit picture that has dropped by almost 100% and a GDP that has dropped by more than 5% for 6 months?

S&P 500 should be at 689, maybe 705 tops.

What I Would Pay For Stocks

I've gotten a few requests for this (even though my advice as of late stinks!):

S & P 500 Index


- Standard & Poor's estimates for 2010 1 year trailing earnings

3/31/2010	$29.48
6/30/2010	$32.32
9/30/2010	$34.61
12/31/2010	$35.67

Average: $33.02


- Average earnings yield since 1988:

4.796%


- Current earnings yield using 2010 forecast:

3.655%


- Implied correction

Drop of 23.795%


- What I would pay for the S & P 500:

688.49


This roughly corresponds to a 6,400.00 Dow Jones Industrial Average.

S & P 500 Earnings: What Are Equities Worth?

In theory, a company's stock should reflect its ability to generate future earnings. Traditionally, equity models would compute dividend pay-out rates based on how quickly those future earnings were expected to grow. In short, the better the earnings prospects, the more you should pay for a company's shares.

In the 4th quarter, the S&P 500 posted its first quarterly loss in history. Think about that, the entire index (on average) lost money.





- The above graph tracks the 12-month trailing earnings on the S&P 500. Currently, the index is trading at 865.30 (down a bit today). Trailing 12-month earnings total $14.88: price/earnings ratio of 58.15

- Some may say "Look at the future smart guy !" OK, I will.

S&P is forecasting the following 12-month trailing earnings:

12/31/09___________$28.51
03/31/10___________$30.83
06/30/10___________$33.49
09/30/10___________$34.59
12/31/10___________$35.31

I didn't bother to post the earlier 2009 numbers because they drop for 3/31/09 AND ARE NEGATIVE FOR 9/30/09.

So, jumping to 2010 we find an average $33.56 earnings number. The forward P/E is 25.79:

- Another way to look at this: the forward earnings yield is 3.88%. Both on a trailing and expectations level, this number has historically been closer to 4.84%

- Index level = $33.56 / 4.84% = 693.29

I would not buy stocks today.