1997: How would Buffett value the S&P 500 index?

AUDIENCE MEMBER: My name is Bakul Patel (PH). I’m from upstate New York. I’ve got a few questions. And I need your permission to ask each question separately and wait for the answer.

WARREN BUFFETT: Well, we’ll take a couple, but —

I got through college, you know, only answering three or four questions. So I don’t want to go through that again. (Laughter)

AUDIENCE MEMBER: They are unrelated questions.

WARREN BUFFETT: OK. OK. We’ll give you a couple, then we’ll let other people have a chance. How about two, OK?

AUDIENCE MEMBER: Fine. Mr. Market is valuing Dow Jones at about 7,000 and S&P at about 800.

By your valuation model, at the current interest rate and current inflation rate and current growth rate, what is a fair valuation of both these companies?

WARREN BUFFETT: Well, that’s a good question but a tough question. But I would say that if you believed American — the American business, in aggregate, could earn the kind of returns on equity that they have been earning in the last — or has in the last couple of years — and then you postulate no change in interest rates, you can justify 7,000 on the Dow and 800 on the S&P.

Now, you know, there’s a couple ifs I threw in there. And if interest rates go higher, the valuation goes down automatically.

And more importantly, if the returns on equity of American industry — which are historic highs, and which sort of classical economics would tell you would be hard to maintain — if those returns go down, on average, that also would pull it down.

But if you’re willing to accept the current level of returns on equity as being typical of the future case for American business and you’re willing to assume present interest rates are lower, then, you can justify a valuation on the Dow and S&P.

And it’s interesting because I got all that commentary after I wrote that line in the report which was, as I said earlier, designed for a little something else. I’ll give you a little trivia quiz.

What two years in this century has the Dow had the greatest overall gain? The two years in the 1900s are 1933, which most of you don’t think of as a banner year, and 1954. And in both of those years, the Dow was up over 50 percent, counting dividends.

In March of 1955, because of that, the fact that the Dow had gone up — bear in the mind that the high on the Dow was 381 in 1929 and it took 25 years before that was surpassed. And in 1954, the Dow went from, say, 280 up to 404, or something like that, just a little over 50 percent.

So what did they decide to do? They decided to have congressional hearings about it. And they did.

In March of 1955, they had hearings in the Senate Banking and Currency Committee, Chairman Fulbright. And my boss, Ben Graham, was called down to testify. And it’s fascinating reading. Bernard Baruch was there, all kinds of people. I’ve got the hearings at home.

And Ben’s opening comments about the market at that time were that the market looks high, it is high, but it’s not as high as it looks. Well — (Laughter)

That’s about the present situation. I mean, it looks very high, just by comparing 7,000, certainly, to the 404 at the end of 1954 when was Ben was testifying.

But there are — there have been huge changing in earnings and return on equity on American business in general. And, then, you had this big move in interest rates.

Now, those are underlying fundamentals that have had — powered a huge bull market. After a while, as I mentioned earlier, people get captivated simply by the notion of rising prices without going back to the underlying rationale. And that’s when you get very dangerous conditions in terms of possible bubbles.

And it would — you know — I have no idea where markets will go. But if you had the kind of conditions that could cause real excesses, just like you had excesses in 1973 and ’4, going back to when you could buy things at 20 cents on the dollar, you had excesses in the other direction.

You know, the country didn’t disappear or anything. It’s just people behave in extreme ways in markets. And over time, that’s very good for people that keep their heads.

Charlie?

CHARLIE MUNGER: I’ve got nothing to add.

WARREN BUFFETT: OK. You get one more. (LAUGH)