Almost 10 years have passed since then Federal
Reserve Chairman Alan Greenspan proposed a
quantifiable methodology for determining the over- or
under-valuation of the stock market’s earnings yield.1
His suggestion, in its simplest form, was that the value
of any stock or bond to an investor is simply the
present value of its future stream of earnings.
Therefore, converting the price-earnings ratio (P/E) of
the stock market to an earnings-price ratio (E/P)
arguably gives investors an apples-to-apples
comparison of the relative yield of the stock market to
the yield of the 10-year U.S. Treasury note.2 The
exercise—though such “Fair Value” calculations were
never officially endorsed by the Federal Reserve—
gave Dr. Greenspan a back-of-the-envelope
assessment of currently prevailing equity valuations.
However, members of the academic and financial
communities questioned Dr. Greenspan’s
methodology. They argued that the lynch pin, and
thus the potential fallacy of the analysis, resided in the
accuracy of future-earnings forecasts. After all, they
are only forecasts of yet to be announced events and
as such are always prone to error. However, in that
the evolving world of financial reporting and most
importantly the advent of the Sarbanes-Oxley Act of
2002 (Act) has altered the context of the issue, I
suggest that investors might consider revisiting Dr.
Greenspan’s controversial shortcut.
Designed to both test and testify to a firm’s
financial statements and internal auditing controls, the
Act brings, I believe, something quite useful to
investors assessing relative valuations of today’s
markets: cleaner data. In fact, analysts at Thomson
Financial, citing their proprietary Earnings Purity
Index, recently noted a marked increase in the quality
and clarity of earnings reporting since the Act became
effective.3
To be sure, not all of the issues surrounding the
standards of Generally Accepted Accounting
Principles (GAAP) are resolved by Sarbanes-Oxley.
Moreover, the Act will not end the debate amongst
investors on the possibility of which, if any,
methodology correctly determines relative values in
the nation’s capital markets. The issue is never that
simple. But if the main objection to a “Fair Value”
approach rested mostly on the accuracy of earnings
reporting, I offer that such objections may no longer
hold true. If earnings reporting is indeed improving,
then I maintain the basic premise of the model—
comparing the relative attractiveness of cash flow
from stocks to bonds—is just that much more
supportable.
1 Federal Reserve Board. Humphrey-Hawkins Report, July
22, 1997, Section 2: Economic and Financial
Developments in 1997, page 29. Available at
Board of
Governors of the Federal Reserve System.
2 Chart courtesy of www.yardeni.com. Used by permission.
3 “Not Everyone Hates Sarbox,” by David Henry,
BusinessWeek, January 29, 2007.
This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its
accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information
in this report does not pertain to any Van Kampen product and is not a solicitation for any product.
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