model that compares a stock to the 10-year Treasury bond. The 10-year Treasury bond is a safe alternative to risky stock investments. Figure 8.1 shows the projected return on a $100 investment in the next year for Microsoft stock and for the 10-year Treasury bond.

Investing $100 in a Treasury bond earns $4.40 in interest per year (at current rates of 4.4%). The person who puts $100 into Microsoft stock (at $28) will receive a dividend of $1.14. In addition, $100 of Microsoft stock buys ownership in additional profits that will be retained by the company. This figure for 2005 at Microsoft is expected (by Wall Street analysts) to be $3.43 for every $100 investment.

So is Microsoft stock a good investment? The answer is that it depends on your optimism about the future. The T-Bond is going to pay $4.40 a year for 10 years and then you will get back the $100 investment. Microsoft stock could be much better or much worse. The payoff to Microsoft is the fact that it could grow substantially. Microsoft is far riskier, however, than the government bond and even big companies can go bankrupt. While the bond investor can be pretty confident of getting

$5.00 $4.50 $4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00

$3.43

$1.14

$4.40

□ $ earned but not paid

□ $ paid in 2005

Microsoft

10-year T-Bond

FIGURE 8.1 Microsoft vs. 10-Year T-Bond (1-Year Return on $100 Investment)

Sources: Federal Reserve, Microsoft, The Wall Street Journal

back the original $100, the stock investment contains an element of speculation.

Is the risk of stock investing worth the reward? Before addressing this question, Figure 8.2 shows the same calculation for the S&P 500.

A $100 investment in the S&P 500 is estimated to return $5.92 in expected 2005 profits versus $4.57 in Microsoft profits. So the stock market places a premium valuation on Microsoft profits, presumably reflecting the superior value of the companys franchise. Beyond this difference, an investment in the S&P 500 also yields more money today in dividends than a similar investment in Microsoft.

This Fed model framework provides an easy summary of optimistic and pessimistic views on U.S. stocks.

The pessimistic view of stocks (Figure 8.3) is that earnings will be (or actually are) lower than projected. The negative view on earnings includes both a pessimistic view on the economy as well as the way in which earnings are calculated. Accounting rules still allow for earnings games related to issues including stock options and pensions. In addition,

$7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00

$4.11

$1.81

$4.40

□ $ earned but not paid

□ $ paid in 2005

S&P 500

10-year T-Bond

FIGURE 8.2 S&P 500 vs. 10-Year T-Bond (1-Year Return on $100 Investment)

Sources: Federal Reserve, Standard & Poors, Goldman, Sachs & Co.

$7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0. 00

$2.05

$0.90

S&P 500

$5.96

□ $ earned but not paid

□ $ paid in 2005

10-year T-Bond

FIGURE 8.3 A Pessimistic View of Stock Prices (Return on $100)

Sources: Federal Reserve, Standard & Poors

most pessimistic stock analyses include an expectation of higher interest rates. Thus, the pessimist contrasts lower stock returns to higher bond interest rates and concludes that stock prices are too high.

The optimistic view centers on the growth in earnings. The optimistic chart (Figure 8.4) assumes that the economy will grow modestly and that corporate profits will grow at the same rate as the economy. As well see, profits have had a good run where they have done better than the economy, but even with the more conservative assumptions, it is easy to build a positive case for stocks. (Figure 8.4 assumes 7% annual growth in the economy, which could come from 3% growth in productivity, 3% inflation, and a 1% growth in the population.)

Even though this Fed model view of stocks avoids many of the details, we can already draw some conclusions about stock valuations.

Stock Prices Do Not Look Ridiculously High

Stock and bond returns are about equal. Good arguments can be made to suggest that stocks are expensive or cheap. This balance of possible reward and risk is characteristic of fair value.