Would you buy this company? by Shawn Tully @FortuneMagazine October 31, 2014, 2:02 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons Two weeks ago, it looked like the start of a big market correction driven by investors who reckoned that stocks were just too expensive and had decided that prices needed to fall far, far lower to restore their allure. Suddenly, the downward trend has fully reversed, and the S&P 500—after losing all of its gains for 2014—is surging towards a new record. So if stocks looked expensive before the brief swoon, investors are voting once again that they deserve premium prices. Put simply, the new jump in valuations reflects an overwhelming optimism that America’s companies will perform mightily in the years ahead. Of course, the metric that matters is how fast the Apples, Facebooks ,and Exxon Mobils can grow their earnings. By bidding S&P shares 11% higher over the last two weeks, investors are effectively admitting that their doubts were unfounded and betting that future earnings will prove absolutely stellar. Now, we don’t know how profits will actually perform, but we do know how they have to perform to satisfy the new spike in expectations. So here’s what equity owners should be thinking about: Imagine that the S&P 500 is one gigantic company, a conglomerate that owns everything but features a high concentration in fields like glamorous technology. We’ll call it S&P Inc. So is S&P Inc a stock you should buy? Let’s look at S&P Inc’s fundamentals, its valuation, dividend yield, and, most of all, how fast its earnings must wax to enrich its shareholders. With the S&P standing at around 2015, S&P Inc is selling at 20 times earnings, based on the last four quarters of fully reported net profits, totaling around $100 a share. To determine whether S&P Inc is a buy or a sell requires a few assumptions. We’ll purposely make them modest. Let’s assume that investors expect future returns of 8%, including inflation of 2%. S&P Inc is paying a slim dividend of less than 2%. So most of our return must come from earnings growth, and that’s the rub. What’s the rate of earnings growth needed to reach our 8% goal? The answer doesn’t scare like a Halloween hobgoblin. S&P Inc will deliver if earnings expand at 10% annually for the next five years, measured from the end of June 2014, the last quarter of fully reported earnings. In that scenario, S&P Inc would need to be trading at around $161 a share by mid-2019, a 61% increase. After that initial spurt, its profits could march ahead at 6% a year pretty much forever. Its P/E would drop to about 17 in this later, slower-growth, mature period, reflecting lower expectations for earnings gains going forward. Listening to Wall Street pundits and market strategists, you’d think 10% earnings growth is an easy target. It’s anything but. That pace exceeds the rate of inflation by at least 8 points. Consider that America’s output is unlikely to grow at even 3%, adjusted for inflation, over the next five years. To make matters worse, while total earnings typically grow with the economy as a whole, earnings per share rise far more slowly, mainly because pioneers and existing players are constantly challenging entrenched producers. Over time, the growing number of competitors, foreign and domestic, keeps cutting the pie into smaller and smaller pieces. Handicapping whether profits will soar or lag also depends on the starting point. When earnings are unusually low, the chances they’ll jump—and, hence, return to normal levels—are far better than when they’re at an historic peak, which is when they are more likely to decline to normal levels. And that’s just where we stand today. Earnings as a percentage of sales, national output, equity, and any other measure are at or near half-century highs. For example, for the 2013 fiscal year, Fortune 500 total earnings reached 8.85% of sales. The average since 1995: 5.24%. So here’s the answer. The momentum says S&P Inc is a buy. The numbers say it’s a sell. If the “big earnings” scenario doesn’t play out, the only way S&P Inc can reward investors in the future is by resetting to a lower price. Based on the fundamentals, you wouldn’t want to buy this company.