Not trying to be right, perhaps “less wrong”

If you had a chance to read my last post “The Pent-up Demand Fairytale” you will find that I am very critical of the pent-up demand argument supported by Treasury Secretary Steven Mnuchin and Economic Advisor Larry Kudlow. My criticism to their argument is backed by the current characteristics of the U.S economy. In fact, 70 percent of the U.S economy is consumption driven and 70 percent of it is service related rather than manufactured goods. Hence, I claimed that there might be a very high likelihood that about 49 percent of the U.S economy looses caused by COVID-19 could be permanent or at least could take years to be recouped, resulting in a possible “L” shaped recovery.

On the other hand, more optimistic analysts, might claim that the looses caused by the COVID-19 are only temporary and that the liquidity provided by the Federal Reserve would be sufficient to ramp up the economy resulting in a fast fashion “V” shaped recovery or at the very minimum an “U” shaped one.

My goal with this post is to try to give readers some perspective by evaluating all three prepositions (“V”, “U”, “L” shaped recoveries) by coming up with an estimated intrinsic value of the S&P 500 index using the discounted cash flow valuation which assumes that the value of an asset is the present value of its expected cash flows discounted back at a rate that reflects the riskiness of these cashflows.

Three main assumptions are essential in the following analysis.

a- The magnitude of the looses caused by the shutdown due to COVID-19

b- The timespan in which the looses will be recouped once the economy is reopened.

c- The percentage of earnings companies would be willing to payout to investors from now on.

For credit purposes, the bulk of this analytical framework was developed by professor Aswath Damodaran which is considered one of the brighest minds in the valuation field. On a side note, the implied equity risk premium used in the following analysis was also retrieved from his website.

“V” shaped recovery scenario

In the “V” shaped scenario the estimated intrinsic value of the S&P 500 index is $3336.47. The bull narrative is backed by the assumption that the 25% drop in EPS are temporary and will be rapidly recouped by the end of year 2. This analysis assumes that the monetary and fiscal stimulus were effective to support future economic growth. It also assumes that there will be considerable pent-up demand as expected earnings per share increases by 57.77% if compared to the period before COVID-19. Lastly it is assumed that the cash payout as % of earnings is constant at 87.96%, which means that companies will continue with their stock buyback programs at full speed.

“U” shaped recovery

In the “U” shaped scenario the estimated intrinsic value of the S&P 500 index is $2605.84. The narrative is backed by the assumption that the 40% drop in EPS will only be recouped by the end of year 3. This analysis assumes that the monetary and fiscal stimulus were somewhat effective to support future economic growth, but it denies the pent-up demand argument. Lastly it is assumed that the cash payout as % of earnings decreases from 87.96% in 2019 to 85% in 2025, which means that companies will be forced to slightly decrease their stock buyback programs.

“L” shaped recovery

In the “L” shaped scenario the estimated intrinsic value of the S&P 500 index is $1801.39. The main narrative is backed by the assumption that the 40% drop in EPS will only be fully recouped by the end of year 5. This analysis assumes that the monetary and fiscal stimulus were not effective to support future economic growth and demand and supply destruction. Lastly it is assumed that the cash payout as % of earnings decreases from 87.96% in 2019 to 80%, which means that companies will be forced to decrease their stock buyback programs considerably, a very realistic assumption given the mainstream backlash against companies that spent millions in stock buybacks in recent years and yet urged for government assistance to stay in business.

Final Remarks

As can be seen, trying to estimate the intrinsic value of an asset such as the S&P 500 index involves many critical assumptions which might lead to fairly different results. However, my goal with the presented analysis is not to tell you whether you should buy or sell the market, but to provide you an analytical framework where you can try to quantify your own expectations without having to depend on any economic cheerleader’ advice. Hence, think critically through each one of the assumptions and do your best judgement. At the end of day you do not need to be right to make money, you just need to be less wrong than your counterparty.

• I welcome you to leave your email address on the comments section below if you are interested in having the analytical framework file.