Financial analysts it seems are always playing games. If
you ask ten of Wall Street's analysts what is the market's P/E
ratio, you are likely to get ten different answers. You also
will no doubt notice that most of their answers will suggest the
market is currently "fair" or even "undervalued".
Which of these S&P 500 P/E ratios is correct? 18.2x,
15.5x, or 13.0x?
This is a trick question because all three are correct. But
which one you choose will obviously make a massive
difference in assumed valuation. Put another way: 18.2x is
42% larger than 13.0x, and is a major discrepancy and
potential disaster for your portfolio.
How it is Supposed to Work
The P/E ratio is a valuation metric that takes the price divided
by a company's earnings to come up with a ratio that can be
compared across comparable assets through time. In short the
P/E is used to help decide if stocks are expensive, fairly valued,
As the ratio implies there are two inputs needed. The
numerator, price, is typically straightforward and usually the
current asking price of the market or stock being
The denominator is where the issues arise. The earnings
piece of the ratio it seems can be interpreted an infinite amount
of ways, and therein lies the rub. Deciding which earnings
assumptions to use is the crucial step in understanding the P/E
ratio you are about to invest in.
Why all the Earnings Differences?
The earnings piece of the equation can be broken into three
What kind of earnings is being used, what kind of reporting
technique is being used, and finally what year of earnings is being
assumed are three questions to help decipher the P/E code.
First, what kind of "earnings" is being used? There is net
income earnings, operating earnings, earnings before taxes,
earnings before interest and taxes; the list literally goes on and
on. Most P/E ratios use the bottom line "net
The second item to figure out is if earnings are based on "GAAP"
or "Operating" techniques.
From Standard & Poors, the go to source for S&P 500
(NYSEARCA:IVV) earnings analysis, "operating income excludes
corporate (M&A, layoffs, financing) and unusual items".
These items are typically considered non-recurring by management
and are backed out of expenses. Operating earnings (also
known as management earnings) is used to try to give a smoother
view of earnings, attempting to exclude those items which may not
GAAP earnings on the other hand include all these costs and are
based off of Generally Accepted Accounting Principles, which is
what is reported to the SEC in quarterly filings. GAAP
earnings are also known as "reported earnings".
The final thing to figure out is the year of earnings
used. Since earnings are (wrongly) always expected to grow
over time, analysts can take advantage of the rising earnings
estimates to lower the P/E ratio. Simply, using forward
earnings estimates provides a larger earnings number which lowers
the P/E ratio. This is usually how the "earnings games" are
Why it Matters
Tackling each of the three questions can keep things consistent
and allow for better analysis. It also will help you decipher
what the real P/E ratio should be. Sticking with the same
kind of earnings as well as the same technique used each quarter is
a great start and will provide consistent comparable P/E analysis
In the following table I show two of the three earnings
inconsistencies, the technique used (Management or GAAP) and year
assumed, and show how it drastically changes the P/E ratio.
The data is from Standard and Poor's and uses net income earnings
for the S&P 500 (NYSEARCA:SSO) companies.
The primary driver between the two extreme P/E ratios is the date
assumed. By using earnings from Dec 2014, an analyst can
instantly drop the P/E ratio over 30% (from 16.2x to 12.9x).
No big surprise, whichever period provides the lowest P/E is
typically the P/E ratio that is quoted by the media, justifying why
stocks (NYSEARCA:SDY) are indeed cheap (the long term average P/E
ratio is around15x).
The difference between the GAAP and Management earnings makes a
difference, but not near as much as the time frame assumed.
By pushing out the earnings horizon, P/E ratios drop over 4 handles
based on GAAP.
Think this discrepancy is extreme? The difference of the
P/E on the Russell 2000 (NYSEARCA:IWM) dwarfs this
discrepancy. The current Russell 2000 P/E based on trailing
1Q 2013 GAAP earnings is 58.7x, but the P/E expectation one year
from now is only at 17.2x.
What if small cap (NYSEARCA:UWM) earnings don't grow next
year? That will mean next year's P/E in reality is much
higher than 17.2x. Don't worry though, by that time analysts
will have you focusing on the expected growing 2015 earnings, again
trying to justify a low P/E and time to buy.
What to Do
Any earnings in the future are still just estimates, but the Mar
2013 GAAP reported earnings are actual, already occurred, and
real. Essentially you must believe the analysts' estimates
for higher and higher earnings to justify a currently low
P/E. If you want something more tangible, then using actual
reported earnings from Mar 2013 is the route you should take, and
that suggests P/Es are high now.
These earnings games are why as far back as September in our
Profit Strategy Newsletter
we included in our list of 12 Mega Themes "equity valuation
risk". We warned, "Cyclical earnings and margins are near all
Since then earnings have flatlined as margins have indeed
contracted and P/Es have gotten much larger. This continues
through today, where again our Mega Theme again highlighted,
"Fundamentally driven bull markets should rely more on earnings
growth and less on investor's willingness to pay ever increasing
Just because analyst expectations are for continued earnings
growth doesn't mean that earnings will ever get there. Did
you know that March 2013's GAAP earnings are actually lower than
March 2012's? This means earnings have not grown in over a
year, yet analysts are still expecting significant growth through
Looking deeper into the earnings piece of the P/E ratio may help
investors avoid buying a market the pundits continually insist is
trading below historical averages.
In reality the market can be considered cheap and trading under
14x only if earnings indeed can grow over 30% over the next seven
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