Is The S&P Valued Too Low?

On February 25 I published an op-ed piece in the ‘Wall Street Journal' entitled, "The S&P Gets Its Earnings Wrong." In that article I said that, although the S&P weights each individual's stock by its market capitalization to compute the return on the S&P 500 Index, no such methodology is used to compute aggregate earnings of the index.

As a result, the billions of dollars of losses racked up by, say, AIG, whose market value is extremely low, is added dollar for dollar to the earnings of the profitable firms, such as Exxon Mobil, whose market value is more than 20 times larger. I maintained that S&P's methodology gave far too much influence to firms with big losses and low market values, and thereby gave a distorted valuation to the S&P 500 Index.

A Challenge to Standard & Poor's

I proposed an alternative methodology for computing aggregate earnings: Weight the earnings of each company by its current market value, in a fashion identical to the way the return on the S&P 500 Index is computed. This alternative methodology leads to substantially higher earnings for the index than does the S&P methodology.

According to Standard & Poor's, total reported earnings on the S&P 500 index for calendar year 2008 was a mere $14.97, the lowest in many decades, primarily because of the huge losses of a few financial firms. S&P reports that, at the index's level on March 31 of 798, the S&P was selling at an extraordinarily expensive 53.3 times last year's earnings.

Yet S&P's own Web site says that "AIG's record setting Q4 '08 'As Reported' loss of $61.7 billion, or $22.95 per share, took $7.10 off the index." AIG's quarterly loss was so massive that it more than canceled out the entire year's income of Exxon Mobil, which earned $45 billion in 2008. For the full year, AIG lost over $99 billion, more than twice the total profits of Exxon Mobil.

Where the Distortion Comes In

Here is where the distortion comes in. Exxon Mobil has a market value of $350 billion, while AIG's value is now a mere $15 billion (and it was only $5 billion a month ago). That means that the average investor owns more than 20 times as much Exxon Mobil stock in their virtual portfolio as AIG stock, so that for the average virtual portfolio of those two stocks, the oil giant has over a 95 percent share and AIG has less than a 5 percent share.

S&P says that an investor holding 95 percent of his virtual portfolio in Exxon Mobil and 5 percent in AIG has negative aggregate earnings and an infinite price-to-earnings ratio because the losses of AIG are greater than the profits of Exxon Mobil, no matter how much you hold in each. S&P would say this even though 95 percent of your virtual portfolio is in Exxon Mobil, a stock that sells for less than 8 times its earnings.

My methodology would weight the $45 billion earned by Exxon Mobil by 95 percent and the $99 billion loss of AIG by 5 percent to obtain a weighted average earnings of $39 billion for the virtual portfolio. With a weighted average market value of AIG and Exxon Mobil  of $335 billion, this would lead to approximately a 9 P/E ratio for the virtual portfolio, not the infinite P/E computed by Standard & Poor's.

With a few firms sporting huge losses, weighting the gains and losses by market value gives a much better picture of the market's current valuation. Instead of reported earnings of $14.97, the market-weighted earnings is a much higher $71.50, which gives the market a P/E ratio of just over 11 instead of 53.3, as reported by S&P.

The big losses in the financials impact operating as well as reported earnings. S&P reports that total operating earnings for the S&P 500 was $49.49 in 2008, giving the Index a 16 P/E ratio. Once the earnings are weighted by market value, operating earnings rise to about $79.40, giving the market a very cheap P/E ratio of 10.

S&P's Response

After my article appeared, a flood of emails and phone calls came not only to my office but also to Standard & Poor's. David Blitzer, the managing director and chairman of S&P's Index Committee, posted a letter on their Web site defending their methodology and claiming that my methodology "failed the simple tests of both logic and index mathematics. A dollar earned or lost is the same, irrespective of whether it is earned or lost by a big index constituent or a smaller one."

S&P continued, "To use an analogy, we could hypothetically view the S&P 500 as a single company with 500 divisions, with each division having earnings and an implicit market value. The smallest of these divisions could have an outside loss that wipes out the combined earnings of the entire company. Claiming that these losses should be ignored or minimized because they came from a less valuable division is flawed."

What is completely flawed are the logic and economics of the above paragraph. The independent corporations that make up the S&P 500 Index are valued completely differently than if they were divisions of one company. The losses of one company do not cancel the profits of another. Exxon Mobil's shareholders are not impacted by AIG's losses. In fact, AIG's losses are now taken by the bondholders — or, to the extent the government bails out the bondholders, we, the taxpayers, shoulder AIG's loss. Liabilities do indeed cross the divisions of a single firm, and that is why the New Products Division of AIG tanked the many other profitable divisions of the insurance giant. But these losses do not cancel the earnings of profitable firms.

A Point Well Taken

My good friend and colleague Prof. Robert Shiller of Yale University, who has used S&P earnings extensively in his work, agreed that my point was very well taken. He said that the basic economic principle comes from the theory of options. The value of a firm's equity can be viewed as an option on the total value of the firm, after the bondholders and other claimants have been paid. It is a fundamental theorem of option theory that the sum of the option prices on individual firms is worth more than a single option on the value of all the firms. In other words, the sum of stock prices of 500 stocks must be worth more than "a single company with 500 divisions," as David Blitzer claims the S&P 500 Index represents. This is particularly true if one or more of the divisions has extreme losses, as do AIG and many of the other financials.

Prof. Shiller did say that the theory does not lead directly to my methodology of value weighting, and probably the "true" earnings of the S&P is a far more complicated function of the individual firms' earnings. The true earnings may in fact lead to even higher values than I have calculated. My calculations on historical data show that, in most years, it makes little difference whether earnings are calculated by market value or by using the simple sum as S&P does. This is because when earnings are positive, the two methodologies give similar results.

But as option theory indicates, when the earnings of a few companies turn sharply negative, there is a big difference between the two methodologies. Back in 2002 the aggregate earnings of the S&P 500 Index also plummeted when a few firms, such as AOL and JDS Uniphase, took huge writedowns on some of their Internet investments. Reported P/E ratios soared into the 60s in the second quarter of 2002, yet rather than being overvalued, the market was just approaching its bear market low.

Final Word

The true valuation of the market is no where near as dismal as the aggregate earnings reported by Standard & Poor's suggest. When virtual portfolios of stocks are weighted by market values, the market is cheap by historical standards. No one can say for sure whether March 9 will mark the bottom of this dismal bear market (I personally think it will), but I am sure that investors who hold a diversified virtual portfolio of stocks today will be rewarded by above-average returns.