Are we really in Another Bubble? From the Popular Internet Video to Marketwatch.com

This hilarious internet video has been going around the internet lately. The singers, singing a song to the tune of Billy Joel's "We Didn't Start a Fire", sing a song asking if there is another Bubble.

Video Here

This video has been so popular, that even reputable Financial Services company Marketwatch.com has written about the video.

Marketwatch Article About the Bubble Internet Video

But are we really in a Bubble?

In 2000, Jeremy Siegel, in an article in the Wall Street Journal, wrote that of the 33 largest firms based on market capitalization, 18 of those were technology stocks, and their market weighted PE equaled 125.9. Mr. Siegel also mentions that half of the large cap technology stocks had PE ratios over 100.

Compare this with 2007, where even fast growth stock Google (GOOG), has a current forward PE of 32.74, a 5 year estimated growth rate of 34.41%, for a very low Price Earnings to Growth Rate (PEG) of 0.93, a very low ratio under 1.

So while some stocks now could be overvalued, this time it is different. This time there's real earnings, and prices, even for top growth stocks like Google (GOOG), seem fairly reasonable.

Historical S&P 500 PE Ratios and Earnings (Aug. 15, 2007)

From 1988 to August 15, 2007, the average trailing Price to Earnings (PE) ratio of the S&P 500 was 22.7. As of August 15, 2007, the current trailing PE ratio of the S&P 500 is 16.3.

Since we are using the years 1988 to 2007, this overweights the great bull market of 2000 including the Bubble. According to Wikipedia, the average PE ratio of US Equity from 1900 to 2005 is 14 or 16 depending on how you calculate it.



When we look at quarterly earnings (as reported), we notice that earnings from 1988 to the peak of the bubble rose 3 times. From 2003 to 2007, earnings of the S&P 500 rose 5 times!

Yet, if we look at the historical PE, the S&P 500 PE is still a very reasonable 16, and if we look at forward (estimated) PE as of August 15, when the $SPX was 1406, we notice that the S&P 500 forward PE is a low 14.75. This would suggest that the S&P 500 has room to run.

At the moment, the Fed is likely to cut rates. In a falling rate environment, PE ratios can have even more room to expand.

There are also models which look at the yield on the ten year bond to estimate the PE ratio of the S&P 500.

The Ten Year Treasury Bond Yield ($TNX. Divide $TNX by 1000 to get Yield) is currently (August 24, 2007) 4.63%. To estimate the potential PE ratio based on that, we take the reciprocal of the yield, to get 1/.0463 = 21.6.

A low inflation rate is also good for stocks.

Based on all this, the S&P 500 may have room to run to the upside.

Latest S&P 500 estimates from Standard and Poors

Improved Version of the PEG Ratio

In a previous article, we used the PEG ratio to evaluate a stock. While the PEG ratio is a good method, I've decided to create my own variation of the PEG ratio which I'll call MyPEG.

The Formula is this:

MyPEG = ((Current Price - Cash Per Share) / Forward Earnings) /
(Yield + 5 Yr Estimated Growth Rate).

What this does is take into consideration the dividend yield of a stock. It also takes into consideration how much cash is in the stock. As legendary investor Peter Lynch said, by taking cash per share into the equation, we might be able to find great bargains out there.

We will still use MyPEG the same way as PEG. A MyPEG < 1 means the stock is cheap, while a MyPEG > 2 is very expensive. We can compare stocks using MyPEG, but it's better to compare stocks in the same industry.

How to find the numbers through Finance.Yahoo.com

Go to Finance.yahoo.com and enter your stock symbol. You get a nice summary page with basic information and news. A very useful page is the Key Statistics Tab.

You can find this information there:

1. Market Cap: Top Part of Page
   
2. Trailing PE: Top Part of Page
   
3. Forward PE: Top Part of Page
   
4. Price: Very Top of Page
   
5. Cash per Share: Bottom Left side under Balance Sheet.
   
6. Yield: Lower right corner under Dividends and Splits
   

Another useful tab is the Analysts Estimates Tab.

You can find this information there:

1. Trailing 12 months Earnings: Top part of Page, look at Year Ago EPS under Current Year (Dec-07).
   
2. Current Year Earnings: Top part of Page, look at Avg. Estimate under Current Year (Dec-07).
   
3. Future Earnings: Top part of Page, look at next Year, Avg. Estimate
   

So to calculate the MyPEG of General Electric (GE):

MyPEG = ((Current Price - Cash Per Share) / Forward Earnings) /
(Yield + 5 Yr Estimated Growth Rate).

1. Current Price (June 22, 2007): 38.24
   
2. Cash Per Share: 1.872
   
3. Forward Earnings: 2.49
   
4. Forward Yield: 2.90%
   
5. 5 Yr. Estimated Growth: 10%
   

MyPEG = ((38.24 - 1.872) / 2.49) / (2.9 + 10)
= 1.13

Note regarding Banks and Brokers

You shouldn't use items like Cash Per Share in companies such as Banks or Brokers. It won't be accurate. Just see the Cash Per Share of Goldman Sachs (GS): 1,769. Not a valid number to use in the MyPEG formula.

Credits

I came up with adding Yield to the 5 Yr. Growth Rate by myself. I was inspired to use the cash per share method by reading Peter Lynch's One Up On Wall Street : How To Use What You Already Know To Make Money In The Market, an excellent book. I definitely recommend it. (Other Book Recommendations in the link or to the section to the right).

I combined both methods and created the MyPEG.

Note on PEG and Growth Rates

In other posts such as this analysis of Computer and Video Game Stocks, I often put in this section regarding PEG and Growth Rates because Growth Rates are estimates and may not be as reliable:

"When choosing between a stock that has a PE of 15 and a growth rate of 15% vs. a stock that has a PE of 30 and a growth rate of 30% (both have a PEG ratio of 1), I'll prefer the former. The reason is that high PE's are often priced to perfection. Any miss and high PE stocks can get hit very hard. Stocks with Lower PEs have less expectations and have a greater margin of safety. Another reason is that I have more confidence in the forward PE than the 5 yr. estimated growth rate. So the results are better by preferring the lower PE stock given an equivalent PEG or MyPEG because the 5 year growth rate is given less importance. Lastly, stocks can't maintain 30% plus growth for long periods of time, so growers from 15-30% might be preferred."

S&P 500 Target Estimate based on Ten Year Bond Yield

I recently read an interesting article by Frederic Ruffy of optionetics.com . One of the interesting parts of the article is a way to estimate the S&P 500 based on the yield of the ten year bond. Full Article Here

Currently, the Ten Year Yield (based on $TNX ) is approximately 5.137%. On an S&P 500 Earnings basis as Reported (estimates top down) as of 6/4/2007:

2006 Estimate: 81.51
2007 Estimates: 88.74
2008 Estimates: 96.40

With the formula:
S&P 500 Estimate = [1/(Ten Year Yield)] * (S&P 500 Earnings)

2006 S&P Target = [1/(.05137)] * 81.51 = 1586.7
2007 S&P Target = [1/(.05137)] * 88.74 = 1727.5
2008 S&P Target = [1/(.05137)] * 96.40 = 1876.6

With the current S&P 1509.12, is the 2006 S&P 500 5% undervalued?

And if we look at the 2007 estimate, the S&P 500 is 14.4% undervalued, and based on 2008 estimates, the S&P 500 is 24% undervalued.

Are these target prices reasonable?