Friday, October 09, 2009

Is the market over-valued?

Many Yo-Yo financial reporters are yelling and screaming about the stock market being over-valued. This may be the case, but many of them are using trailing P/E ratios to justify their hypothesis. This is ridiculous logic, so before you accept their conclusions, let me explain.

For a trailing P/E, they may take the S&P 500’s current price of 1068 and divide by the index’s 2008 as-reported earnings of $14.88. This simple calculation yields a P/E ratio of 72x. The index’s trailing P/E has averaged 16x since 1936, so at 72x, the market is grossly OVERVALUED, right? Don't agree just yet, because this certainly isn't the case if you analyze the P/E from different perspectives.

It may be fine to calculate a P/E ratio in normal times by looking at previous year’s earnings, but last year was in no way normal. Last year’s earnings are a poor proxy for earnings going forward, so for now, please throw your trailing P/E ratio out the window. It is useless.

It is also illogical to use as-reported earnings at this time. In 2008, and continuing on for the next few years, you will see a lot of charges in between the operating and net lines of most companies’ income statements. Financial companies have taken massive losses due to asset write-downs, and other firms have incurred huge restructuring charges to align themselves for a more profitable future. As-reported earnings captures all of these charges, but since they are transitory and astronomically high for now, they shouldn't be included when hypothesizing the over/under valued-ness of the stock market.

Instead I would advise looking at a forward P/E ratio based on operating earnings, which doesn't include those transitory costs. Using 2010 operating earnings expectations should give us a more normalized picture of profitability going forward. Either way, it is certainly a more accurate proxy than 2008 figures.

The forward operating P/E for the S&P 500 has averaged around 19x for the past 20 years. S&P estimates 2010 operating earnings to be $73.47, implying a P/E ratio of 14.5x. From my calculation, the stock market appears CHEAP.

Writers want to sell stories. In deciding that the market is expensive, and since many people follow P/E ratios, they fandoongle the ratio to outrageous numbers to grab your attention and support their conclusion.

When times return to normal, go ahead and bring back your trailing P/E ratio, but for now, don’t be fooled by their calculations.

Aaron Konen

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