Many investors are confused when they hear the vast majority of portfolio managers and strategists in the media say that the stock market is cheap while the minority bears assert that it is significantly overvalued. After all, aren’t the two sides looking at the same facts? Well, yes and no. The bears look at trailing cyclically-smoothed reported (GAAP) earnings for the S&P 500, a number that we calculate at about $68 for the year ended 2010. The bulls, on the other hand use estimated 2011 consensus operating earnings of $95. On today’s closing price of the index of 1283, we calculate the P/E ratio on $68 at about 19 times, while the bulls divide 1283 by their 2011 estimate and come up with a P/E ratio of 13.5 times. Since both sides are aware that the long-term average P/E ratio is about 15 we see overvaluation where the bulls see undervaluation.
We have three major problems with the way the majority determines the value of the market. First, operating earnings differ significantly from earnings calculated in accordance with “generally accepted accounting principles”, commonly referred to as “GAAP” or “reported” earnings. Operating earnings throw back into earnings a number of expenses considered non-recurring such as severance pay, plant closings, inventory write-downs and any number of other expenses that corporations may want to write off. In the past 10 or fifteen years companies have gotten a lot more creative about what items they can write off, and now a large number of expenses that used to be considered normal are called unusual even when these write-offs are taken year after year. In other words, in too many cases what is called operating earnings is pure fiction. That is why we prefer to use earnings calculated in accordance with generally accepted accounting principles.
Second, the long-term average P/E ratio of 15 is based on trailing reported earnings, not operating earnings. Prior to the last dozen years of sequential bubbles the 71-year average P/E on this basis was 14.5 (rounded to 15). Operating earnings as they are used today did not even exist until the mid-80s when they came into vogue partly as a means of making earnings look better than they would have under the accepted rules. Since operating earnings almost always exceed reported earnings, often by significant amounts, even if we had such results going back further in history, the average P/E on them would be much lower than for reported earnings. For instance in the last 12 years cumulative operating earnings exceeded reported earnings by 23%. This would be enough to reduce a 15 P/E ratio to about 12. In that case the market would be overvalued even on operating earnings.
This post previously appeared at Comstock Funds >
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