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Generational Dynamics Web Log for 30-Oct-07
Another way to obtain the "real value" of the stock market

Web Log - October, 2007

Another way to obtain the "real value" of the stock market

Many people claim that you can't tell if you're in a bubble until it's over.

That may have been true prior to the 1900s, before masses of historical data became available.

But today you can usually tell if something is in a bubble by analyzing historical data.

Shanghai stock market has been skyrocketing for the last year. <font face=Arial size=-2>(Source: wsj.com)</font>

Shanghai stock market has been skyrocketing for the last year. (Source: wsj.com)

Sometimes the bubble is so pronounced that you don't need a great deal of data. That's the case with the Shanghai stock market bubble, as shown by the adjoining graph that I referenced two weeks ago in an article, "Wall Street Journal wonders if Shanghai stocks are in a bubble."

However, many analysts would object to my use of the word "obvious," since only 3½ years of data are used, and that's a fair criticism. It's actually pretty easy to "lie with statistics" when using too little data. I've actually seen analyses that attempt to project trends from only 3 or 4 data points. Such attempts are meaningless.

In my article, "How to compute the 'real value' of the stock market," the current value of the stock market is computed by using three different types of historical data: historical earnings, historical growth rates, and historical book values. All three of these methods come to roughly the same result -- the real value of the stock market today is around Dow 5000, meaning that the stock market today is overpriced by a factor of 250% (same as in 1929).

Here's a graph from that article:

Dow Jones Industrial Average, logarithmic scale, 1900 - August 17, 2007.

Dow Jones Industrial Average, logarithmic scale, 1900 - August 17, 2007.

When you want to extrapolate into the future from historical data, then you have to use many data points. The graph above uses over a century of monthly data, over 1200 data points.

When we're talking about generational trends, which repeat in roughly 80 year intervals (the length of a human lifetime), you need at least a century of data. Frankly, I wish I could use three or four centuries of data, but unfortunately no such data exists.

In the above graph, the red line shows the Dow Industrials for each month since 1900. The blue line is obtained by curve-fitting an exponential curve to the Dow Industrials. (The exponential curve appears as a straight line because the y-axis is a logarithmic scale.) Although more analysis is required to be certain, the graph itself is a good visualization of a bubble.

The graph provides a current "real value" of the stock market -- in this case Dow 5268 on August 17, meaning that the stock market is overprices by a factor of over 250% - same as in 1929. (The trend value for each day is given on my Dow Jones historical page. For October 29, the trend value is Dow 5316.)

This method provides an estimate for the stock market as a whole -- at least as measured by the Dow Industrials stock index -- but does not provide information about different stocks.

Thomas Au's "Investment Index"

Thomas P. Au, with the financial services firm R. W. Wentworth, has developed something called the "Investment Index," which he says measures the "real value" of individual stocks.

Au's formula for investment index is very simple:

      IV = (book value per share) + 10 x (dividend per share)

What's interesting about this computation is that it doesn't appear to have anything to do with historical values. That isn't true, however -- the "book value" is a kind of historical value on its own.

Let's look at the two components of IV:

The "book value" of a company is the amount of money that the company would be worth if it were liquidated today, and all the assets were sold off and the debts per paid off.
The book value of a company (also called shareholder's equity) is computed according to standard accounting rules, and equals the value of all the assets minus the value of the debts.
When an asset is acquired, its book value equals its price. Each year, its value is "depreciated," and the book value is reduced by the amount of depreciation. For example, a manufacturing firm may pay $1 million for a piece of machinery. The life of the machine is estimated to be 10 years, and so the book value of the machine is depreciated by 10% per year, or $100,000 per year. At the end of ten years, its book value would be zero.
Thus, the book value of an asset takes into account its history. To compute the current book value of the entire company, add together the book values of each of the company's assets, and subtract the value of its debts. That's the amount the company would be worth if the company were liquidated today.

Of course in most cases a company is NOT being liquidated today. The assets will NOT be sold off, and the company will continue making money. The second part of the computation provides the amount of the share price attributed to future earnings to the shareholder.
Why is the dividend per share multiplied by 10? That's an approximation to the "present value computation" for dividends paid in the future. The formula assumes that dividends will be paid each year into the future.
Suppose that someone loans you $100, and you promise to pay him in a year at 8% interest, or $108. So the "future value" of $100 today is ($100 x 1.08) = $108. Now turn that around. If $108 is to be paid a year from now, then the "present value" of that payment is ($108 / 1.08) = $100, assuming an interest rate of 8%.
If you're going to receive a $108 dividend every year for eternity, and you assume an interest rate of 10%, then it turns out (according to the formula for computing the present value of an annuity) that the present value is $1080, or 10 x $108.

And so, Thomas Au's "investment value" of a share of stock is made up of two components, one of which represents the historic value and the other of which represents the future value.

In an article entitled, "How far down for the Dow," Au uses his IV formula to compute the value of each of the 30 stocks that make up the Dow Jones Industrial Index, and he comes up with the following table:

Putting a value on the Dow Book Divi- Invest- Price Premium/ Value dend ment Discount Value ($) ($) ($) ($) ($) AIG 42.50 0.75 50.00 63.27 26.5% Alcoa 19.20 0.68 26.00 37.44 44.0% Altria 7.50 2.75 35.00 70.50 101.4% American Express 9.00 0.60 15.00 57.11 280.7% AT&T 18.00 1.40 32.00 41.37 29.3% Boeing 6.75 1.45 21.25 93.90 341.9% Caterpillar 13.00 1.30 26.00 73.57 183.0% Citigroup 26.00 2.16 47.60 42.36 -11.0% Coca-Cola 8.60 1.34 22.00 58.76 167.1% Disney 16.00 0.35 19.50 33.81 73.4% Du Pont 11.20 1.48 26.00 47.16 81.4% ExxonMobil 21.50 1.40 35.50 92.14 159.5% General Electric 11.50 1.10 22.50 40.04 78.0% General Motors -7.75 1.00 2.25 37.60 1571.1% Hewlett-Packard 15.00 0.32 18.20 51.40 182.4% Home Depot 13.75 0.90 22.75 30.76 35.2% Honeywell 11.00 1.00 21.00 58.42 178.2% IBM 15.00 1.35 28.50 112.28 294.0% Intel 6.50 0.45 11.00 26.30 139.1% Johnson & Johnson 16.00 1.60 32.00 64.23 100.7% JPMorgan 36.50 1.50 51.50 45.02 -12.6% McDonald's 13.00 1.20 25.00 56.42 125.7% Merck 9.30 1.52 24.50 53.11 116.8% Microsoft 4.60 0.40 8.60 30.17 250.8% Pfizer 10.25 1.25 22.75 24.07 5.8% Proctor & Gamble 21.50 1.35 35.00 70.80 102.3% 3M 14.00 2.00 34.00 86.62 154.8% United Technologies 19.90 1.36 33.50 76.00 126.9% Verizon 16.80 1.62 33.00 44.27 34.2% Wal-Mart 16.20 0.88 25.00 44.98 79.9% Proration factor 0.484950838 Dow 13552.02 Dow at Investment Value 6572.06 Source: Value Line estimates, author's calculations

Closing prices as of Friday, Oct. 19.

The last two lines of the table tell the story: The Dow was at 13552 on October 19, but the total Investment Value of all of the 30 stocks comes out to 6572.

In my article, "How to compute the 'real value' of the stock market," the three methods that I used came out to a stock market real value around 5000, so Thomas Au's computation comes to a value some 15% higher. I haven't studied Au's method enough to understand why there was this difference, but for the current discussion, the point is moot. A stock market value of Dow 6572 is still much lower than today's bubble value, and means that the stock market is overpriced by a factor of over 200%, still enough to trigger a generational panic and stock market crash.

Interestingly, Thomas Au doesn't seem to believe his own results. I'm referring now to the final statement in the article: "At the time of publication, Au was long Alcoa, Johnson & Johnson and Pfizer, although holdings can change at any time." If Au believed his own results, then he wouldn't be long ANY stocks at the present time. (30-Oct-07) Permanent Link
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Generational Dynamics Web Log for 30-Oct-07 Another way to obtain the "real value" of the stock market

Thomas Au's "Investment Index"

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Generational Dynamics Web Log for 30-Oct-07
Another way to obtain the "real value" of the stock market