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Fair price to book for the S&P


matjone
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If you are going to try to follow the graham 25%-75% stock/bond allocation policy for defensive investors (I think I am the only one on here who does this), you have to try to decide whether the market is over or undervalued.  At what ranges of price to book value would you consider the s&p to be undervalued, fairly valued, and overvalued?  Or would you even consider it a good valuation method?

 

I was wondering about this while  re-reading the essay buffett did on inflation where he explains his equity coupon idea, and I also remembered reading that buffet's valuation technique is to discount cash flows at a constant rate based on historical average bond returns, 7% if I remember right.  If I understand the theory, then theoretically you could take these 2 numbers, along with the payout ratio, and come up with a fair price/book multiple for the s&p by discounting the dividends.

 

I decided to try it and made up an excel spreadsheet to  calculate the fair price to book value.  At 100% payout the fair price/book ratio would be the same as what a 12% bond of equal safety would sell at which would be 12/7=1.7.  At 2/3 payout it is 2.6.  At 50% it is 6 and it gets  ridiculous from there, jumping to 200 when you reduce the payout to 40%.  Guess this will have to go down as another situation where theories and excel spreadsheets aren't going to take the judgment aspect out of it.  If only ben graham could come back to write another edition of the intelligent investor, or at least the 1st part where he talks about current market levels.

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I check shillers pe10 excel file from time to time.  I think it was 24 last time I looked.  I also look at what other value investors are doing and saying, and they mostly seem to think the market is pretty high right now.  I am at 25% right now, but i really wonder if this makes any sense when you take inflation into account.  The only thing I know for sure is that I'm not buying any long bonds.

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jeremy grantham also calculates fair value (read his letters, usually it is embedded within, so might have to read each one).  He calculates based on average P/E but then also normalizes the earnings margin (so that in times like 2007 when margins were abnormally high, the fair value is not effected).

 

This is end up being very similar to the shiller 10 year P/E, since it is fair for margins to remain abnormally high over a 10 year period

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I believe that Graham is misunderstood in many ways.  I think that he is like religion; people use what he says, and parts of what he says, to further their own causes.  Graham was a complex individual and the different things he wrote about often don't completely mesh with each other.  There was Graham the fund manager/investor and Graham the academic.  The investor in Graham did certain things and the academic did certain other things.  He also published over a long life - from the 1920s until the 1970s.  So there are macro factors that weighed on his thinking as he got older.

 

In terms of inflation, if you read the 1st edition of Intelligent Investor vs. the 4th (and last) edition, you can see some differences as the first was written during a low inflationary period and the last during a high period.

 

That being said, I think his methods for calculating whether the market was over or undervalued is deceptively simple.  He typically used the DJIA as a proxy and came up with his view of the value of each component, added them together and voila.  If memory serves, he usually looked at inflation rates, interest rates, etc. more as qualitative factors.  Things to be considered for sure, but as they were ever changing not something to be fully factored into valuations.  I think as he got older he got tired and wanted to look more at macro factors and tests and broad market strategies, however.

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I think it makes more sense to look at the S&P by sector.

 

GE trades at 1.8x book.

AAPL trades at 5.9x book. (and a lot of that is cash)

 

The reason why I think it makes more sense is that the weighting of software (just as an example) was relatively quite low in Graham's day versus today. 

 

What does the apples-to-apples comparison look like?

 

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