Are asset prices in today’s financial markets based on intrinsic value or are asset prices based on the greater fool theory? As economic growth and corporate earnings decrease while stock prices increase do fundamentals even matter any more? In this new normal of no growth, stock prices that only go up and bad news is good news we have to wonder if this market is sustainable. We can define intrinsic value and the greater fool theory as follows…

Intrinsic Value: What an asset is actually worth, rather than its current market value, which may be influenced by market conditions such as a recession or a speculative bubble.

The Greater Fool Theory: The price of an asset is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. In other words, one may pay a price that seems "foolishly" high because one may rationally have the expectation that the item can be resold to a "greater fool" later.

Intrinsic value is based on fundamentals. The fundamental value of a share of stock is equal to the discounted value of all future cash flows accruing to the owner of that share. The owner of a bond receives a coupon payment that is contractual. The owner of a share of stock owns the cash that is left over after all creditors are paid. If the company goes bankrupt then the proceeds from liquating the company’s assets are allocated to creditors first with shareholders usually being wiped out. The risk of owning a share of stock is much greater than the risk of owning a bond so therefore the owner of stock can expect a greater return than the owner of a bond. The historical annual return on the stock market (dividends plus capital gains) over the last 100 years or so was 9.6%. The average return on the 10 year treasury bond since 1953 was 5.96%.

We will define the variable E to be earnings per share and the variable K to be the cost of capital. If the company’s earnings per share (EPS) is expected to be $1 in perpetuity (i.e. all earnings are paid out as dividends and there is no earnings growth) then the equation for the intrinsic value of one share of stock is…

In the equation above M is the price:earnings ratio (PE), which is the multiple that we pay for one dollar of earnings in perpetuity. We can view the historical stock market return as a proxy for what investors in the stock market demand to be compensated for taking stock market risk. The annual cost of capital is therefore 9.6%. If we plug this cost of capital into the equation above then the fundamental (i.e. intrinsic value based) PE assuming no earnings growth is...

Obviously a growing earnings stream is worth more than a constant earnings stream. The downside to earnings growth is that the company has to invest in its balance sheet so as to support it's growing revenue base. We will define the variable R to be return on investment, the variable G to be the earnings growth rate, and the variable P to be the earnings payout ratio (the percent of earnings that are paid out to shareholders vs. reinvested in the company to support earnings growth). The historical average return on investment and payout ratio are approximately 14% and 60%, respectively. Given these assumptions the PE ratio given the historical earnings growth rate is...

US inflation-adjusted GDP has averaged 3.4% over the period 1947 to the beginning of the Great Recession and 2.0% thereafter. GDP in the first quarter of 2016 (annualized) was approximately 1%. Japan’s GDP is now zero. All of the G7 economies are in the same boat where economic growth is falling to near zero levels. Corporate earnings growth has historically been equal to nominal GDP (GDP before inflation) minus one to two percent. If Q1 2016 GDP is indicative of where the G7 economies are heading then earnings growth in this “new normal" is equal to real GDP (1%) plus inflation (1.5%) minus the average deduct (1.5%) = 1.0%. Given these assumptions the PE ratio given the "new normal" is...

The current PE ratio for the S&P 500 is 25 times actual GAAP earnings over the last 12 months. The historical average PE over the last 100 years or so is approximately 15 times GAAP earnings. Given the disparity between the actual PE of 25, the historical average PE of 15, and the fundamental PE of 10.80, today’s stock market may be driven more by the greater fool theory than by fundamentals. Some of the spurious reasons put forth to justify the PE disparity are…

1) Use non-GAAP earnings: Take GAAP earnings and throw out anything that is just too negative and call it transitory. The SEC has threatened to crack down on this practice as it is clearly getting out of hand.

2) Use the forward earnings hockey stick: Assume a never realized ramp up in earnings a few quarters out. This ramp up in earnings never materializes so rather than get rid of the ramp just move it forward a quarter or two.

3) The current low return environment: This assumes that the central banks are bigger and badder than the market economy and can keep interest rates below the rate of inflation forever without causing massive economic damage. Good luck with that!

4) It’s different this time!