What Is The S&P 500 Worth?

S&P recently published its buyback report, which provides details of money returned to shareholders via buybacks.

On a trailing 12 months to September 30, 2011, S&P500 (SPY) companies have returned per share amounts of $25.18 in dividends and $44.30, for a total of $69.48. For the full year, I expect S&P 500 companies will have returned per share amounts of $25.65 in dividends and $47.60, for a total of $73.25. If we assume that S&P 500 companies can grow this value returned at a real growth rate of 2%, an investor who has a long- term real rate of return expectation of 6.5%, should have been willing to buy the S&P 500 at 1,575 at the end September and at 1,660 at the end of December, for this is the discounted value of future cash flows expected to be returned to shareholders. There are 3 major problems with the calculation above:

The first is that at a total value returned of $69.48 at end September and $73.25 at end December, the payout as a percentage of as-reported earnings is 79.88% and 81.51%. These payout levels are elevated in a historic context. Buybacks gained popularity some 20 years ago. Between 1871 and 1990 dividend payouts tended toward 60% of as-reported earnings. I expect the value returned to shareholders via dividends and buybacks will tend toward this long- term payout ratio.

The second is that the use of as-reported of $86.98 and $89.87 at the end September and the end December ignores cyclicality of earnings. While we know that in the very long term, companies can be expected to generate real earnings growth of 2%, we also know that these earnings tend to be volatile over the course of an economic cycle. Economic cycles have a median length of 5.5 to 6.5 years, and so I would argue that using a six-year median as reported earnings would be more constructive than using earnings at a point in time.

I feel using nominal data to determine valuation at a point in time is better, but to measure returns and return expectations, it is better to measure in real terms. To do this the historic S&P 500 numbers will need to be adjusted for CPI.

Based on an expected return of shareholder value of 60% (long-term payout ratio) of six year median as-reported earnings ($72.86) expressed in real terms, gives a fair value of 991 for the S&P 500, assuming a long-term real return expectation of 6.5% and a 2% real earnings growth expectation.

See S&P 500 data below; the first section is nominal data, the second is in real terms (it adjusts for CPI).

(Click charts to enlarge)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.