Since nobody has risen to the bait, let me put a little meat on the bones of my argument that the S&P 500 is overvalued at this point vis a vis any reasonable calculation of intrinsic value.
I returned to yesteryear to dredge up the old fashion notion that what the average investor ought to be valuing is a stream of future dividends. I have never been in Missouri but I like their State motto. To get me to invest in anything you gotta show me the money. Earning are nice. Sales revenue is nice. But show me the money. Show me the dividends I am going to get out of this deal. To value that stream you need a holding period and appropriate capitalization rate. So lets examine the elements.
Dividends. S&P reports that the 500 returned $178 billion in dividends in the 12 months ended Sep 30, 2004. That’s up about 16% from the previous 12 month period. (Thank you GW for investor friendly tax reform) We have to make a guesstimate about how that dividend stream is going to grow in the future. Just for fun, lets throw out that last 16% spurt and focus on the preceeding 15 years which reflect an average dividend growth rate of 5.7%. You might argue for a higher growth rate in dividends, but remember we are just having fun here.
Holding Period. You might argue that the S&P 500 is a perpetuity machine. But I personally, am not planning on living in perpetuity. I know some of the posters here are. But not me. Just for some more fun lets assume that the lights go out permanently in 30 years and no sense valuing dividend streams past the grave. So, if you punch that $178 billion of dividends out 30 years at a 5.7% average annual growth rate you get about $939 billion in dividends at the end of the last year of your life. Not bad so far.
Capitalization Rate. Heres where things get a bit tricky. Everybody has a different take on what constitutes a reasonable rate of return. I personally would start with my reasonably attainable long term risk free rate which is now about 4.5%. To that I would add another say 3% to cover inflation which gets us to 7.5%. On top of that I would have to get rewarded for assuming some market risk. Just for some more fun lets say you gotta give me 2.5% for my lost sleep bringing the total up to a nice round 10%.
Now my old pals Weston and Brigham used to argue that the price you should pay today for this dividend machine is the Net Present Value of the dividend stream plus the net present value of the market price of the asset at the end of the holding period (ie, at the end of 30 years). The NPV of my dividend stream growing at 5.7% with a 10% discount rate is about $3.0 trillion. They define the market price of the asset at the end of the holding period as the Dividend in the final year capitalized at the capitalization rate less the growth rate of the dividends or: P = D/(k-g) where P is the market price; D is the dividend; k is the required capitalization rate; and, g is the growth rate of the dividends. For me P = $939 billion/(.10-.057) = $21.837 trillion. The NPV of that $21.8 trillion 30 years from now discounted at 10% is $1.245 trillion. So, according to W and B, the intrinsic value of the S&P 500 dividend stream to me over my remaining estimated lifetime would be $3.025 trillion plus $1.245 trillion = $4.297 trillion.
