Market participants struggle with P/E distortions

Measures that average out earnings over years are gaining favor

Apr 26, 2009 @ 12:01 am

By Dan Jamieson

Market watchers are in a tizzy trying to figure out if U.S. equities are overvalued, fairly priced or the buy of a lifetime. Stock market multiples that use trailing 12-month reported earnings for the Standard & Poor's 500 stock index are being distorted by huge write-offs, which make stocks look expensive. And even though operating earnings, which strip out one-time events such as write-offs, aren't as distorted as reported earnings, they open up valuation measures to subjective judgments by corporate management, according to some observers. As a result, market participants are making greater use of normalized market multiples — measures that average out earnings over a period of years to reduce cyclical variations. "In the last few months, people have really been looking at these smooth ratios [because] there's a lot of noise" in current earnings numbers, said William Hester, a senior financial analyst at Hussman Econometrics Advisors Inc. of Ellicott City, Md., adviser to the Hussman Funds. "All of these measures are trying to get at the true earnings power of the S&P." In the aggregate, the $23.25 per share fourth-quarter loss of S&P 500 companies — together with low profit estimates for the rest of the year — have created what appears to be a bizarrely overvalued market. According to New York-based Standard & Poor's, as of April 22, the annualized price-to-earnings ratio on the S&P 500 was a lofty 127. That figure is based on its current price and an estimate of reported first-quarter-2009 profits and actual reported earnings from the last three quarters of 2008. S&P estimates that the annualized P/E of the 500 stock index will reach 1,900 by the end of June and -460 by the end of September.
"Those are just not a credible numbers," said Ed Easterling, president of Crestmont Holdings LLC, a Dallas-based research firm, who is a proponent of normalized measures. "I think that companies are throwing in all the kitchen sinks they can find to get write-offs out of the way," said Sam Stovall, chief investment strategist for S&P. Most market participants rely on the trailing 12 months of operating earnings to judge the market's valuation, said Will Geisdorf, a research analyst at Ned Davis Research Inc. in Venice, Fla. Last week, the S&P 500's P/E, based on S&P's top-down (most conservative) operating earnings estimates, was just over 18. In contrast to the -465 P/E that S&P predicts for September based on reported earnings, operating numbers produce an estimated multiple of close to 26. But with the increased volatility in both earnings and stock prices, valuation measures based on one year's worth of operating earnings still can fail to give a good long-term picture of the market's value, observers said.

Famed value investor and analyst Benjamin Graham is credited with being the first to suggest using a market multiple based on multiple years.

He suggested using not less than seven years' worth of trailing earnings, Mr. Easterling said.

Robert Shiller, an economics professor at Yale University in New Haven, Conn., whose book "Irrational Exuberance" (Princeton University Press, 2000) warned about the market's overvaluation, ad-vanced Mr. Graham's concept and has popularized a P/E based on the trailing 10-year average of inflation-adjusted earnings. The Shiller ratio was particularly helpful in warning that stocks had become overvalued in 2007, Mr. Hester said.

What was happening in 2006 and 2007 was that earnings were strengthening, and P/Es were actually coming down, Mr. Hester said. There were analysts saying that stocks were getting cheaper and cheaper, and it caught a lot of people off guard, he added.

The higher earnings were being driven by growing leverage and profits at financial companies, and lower labor costs — trends that couldn't be maintained, Mr. Hester said.

Mr. Shiller's method indicated that stocks were more expensive in that period than at any time aside from the 1990s bubble, he said.

Ned Davis Research uses Shiller's 10-year averaging method and since 1999 has also used a median P/E for the S&P 500, Mr. Geisdorf said.

For the median measure, the company calculates a P/E individually for each company and then pulls the median out of that universe to gauge overall market valuation.

Ned Davis, founder of the firm, developed the median when reported earnings were getting distorted the other way on the upside, Mr. Geisdorf said.

The median multiple is now around 13 to 14. It reached the 8-to-9 level in the late 1970s, near the bottom of the last secular bear market, Mr. Geisdorf said.

Mr. Shiller's market multiple at the end of last month was about 13. He didn't respond to calls seeking comment, but in a February interview indicated that a multiple of 10 would be very cheap.

In a research report last month, Mr. Hester compared Mr. Shiller's 10-year smoothed earnings multiples to levels reached during past recessions.

Using post-World War II data, the current P/E is in the 40th percentile, he found, near the median ratio that you would expect in a recession, Mr. Hester said.

E-mail Dan Jamieson at


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