February 20, 2017

How A Major Bank "Calculated" That 20x P/E Is Now "Fair Value"

Carbon-based traders of a certain vintage - which excludes today's 20-year-old hedge fund managers - may recall a time when a 15x P/E was considered "fair." Not any more. In fact, according to a new analysis by Barclays' equity strategist Keith Parker, which tries to factor in so-called "animal spirits" as a driver of valuation has found that 20x P/E is perfectly normal and fair for the current market, further demonstrating just how deep into the goalseeking rabbit hole US capital markets have fallen.

First, to prove we are not joking, here is Barclays explaining why it is important to quantify animal spirits as a input factor of "permanently high plateaued" P/E multiples:

Core drivers of the P/E multiple and animal spirit indicators

In order to estimate the effects of “animal spirits”, or the potential effects of some of President Trump’s agenda, we first model the S&P 500 P/E using the core fundamental drivers of equity valuations. We then compare the residual from the model (actual minus fitted P/E) to various indicators of “animal spirits” or potential policy changes, including: tax policy, credit spreads, inflation, macro volatility, long-term growth expectations and corporate/consumer sentiment data.

Rates, growth and payouts are the core drivers of the P/E. Using a dividend discount framework, an equity price is the present value of future dividends. Dividing both sides of the equation by earnings, the P/E multiple is equal to the dividend payout ratio divided by the cost of capital minus the growth rate. Accordingly, the US 10y yield, US real GDP yoy and the dividend payout ratio explain 57% of the movement in the S&P 500 trailing P/E multiple from 1955 to 1997. We use the 1955-97 sample period because confiscatory tax policies prior to 1955 distorted returns to equity holders (excess profit taxes, etc), and thus affected valuations, while the 1998-2001 tech bubble would also distort results.

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