Jeremy Siegel: S&P’s Earnings Methodology Is All Wrong


Bullish (and wrong) prof. Jeremy Siegel says Standard & Poors has unnecessarily “shocked investors” by using a bad method of calculating aggregate earnings across the Index.

In a WSJ op-ed, he uses a lot of words to explain a simple argument, which is that EPS should be market-cap weighted. So if a tiny microcap stock like, say, Citigroup (C) loses $10 billion, it’s not as bad as if a major enterprise lost that much. The change he gets by applying a market-cap weighting is important:

As the fourth-quarter earnings season draws to a close, there are an estimated 80 companies in the S&P 500 with 2008 losses totaling about $240 billion. Under S&P’s methodology, these firms are subtracting more than $27 per share from index earnings although they represent only 6.4% of weight in the index. S&P’s unweighted methodology produces a dismal estimate of $39.73 for aggregate earnings last year.

If one applies market weights to each firm’s earnings using the same procedure that S&P employs to compute returns, the results yield a more accurate view of the current profit picture. Market weights produce a reported earnings estimate of $71.10 for 2008 — nearly 80% higher than the unweighted procedure. The reason for this stark difference is that the firms with huge losses generally have extremely low market values and hence have a much smaller impact on the total earnings in the index.

Op earnings, he notes, would be $81, so this just reinforces his long held view that stocks are cheap, cheap, cheap.

Still, what we’d like to see — and if anyone has it, it’d be great if they’d send it along — is historical data using this method. Sure, the 10 P/E ratio sounds good, but what about the change year-over-year, or over multiple years.

More broadly, we’re not sure this matters. In a fairly efficient market, the fact that S&P has a particular methodology for measuring index earnings — no matter how poor it is — probably isn’t impacting too much. It certainly doesn’t have much effect on individual stock decisions, so even if the numbers did “shock” people, we find it hard to believe that that shock would have a signficantly negative impact on the market.