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Is Fair Value Obsolete?

The Fair Value concept holds that stocks, and the market in aggregate, have a value based on past, current, and future estimates of earnings. To oversimplify, when you buy a stock, you buy a piece of a business. The questions to ask when buying a stock are what has the business earned, and what is the business expected to earn in the future? The stock’s fair value is then determined by the current and expected earnings. This is measured by the Price/Earnings (P/E) ratio.

For the S&P 500, which consists mostly of the country’s 500 largest corporations, the average historic P/E ratio has been about 15 times its GAAP (see previous entry) earnings. But in the last 20 years or so, the P/E ratio has started to vary wildly, reaching extremes in 2000 and 2007. Today it is 24 times its GAAP earnings. The S&P 500’s price is overvalued compared to what Fair Value would suggest.

Is the concept of Fair Value obsolete? Why is the market’s P/E ratio significantly higher than the historic average? Is it that our government now has a policy of supporting the stock and bond markets? Is it that the introduction of new computerized trading programs by hedge funds has raised the level of Fair Value?

To return to Fair Value’s historic average either stock prices must retreat or corporate earnings must rise. Currently, the market is up while our economy has not yet delivered strong corporate earnings. Hopefully, earnings will rise rather than stock prices dropping because over the long run, I suggest Fair Value will ultimately prevail.