P/E Ratio – it can be confusing and misleading

About three months ago Charlie Minter and Marty Weiner wrote a very succinct article entitled “What’s the Real P/E Ratio? – The bearish view on earnings makes the most sense” , trying to clear up the massive confusion that usually surrounds P/E ratios that are quoted by analysts, in the context of overall market valuation.

Specifically, they give the example whereby you could be listening to two talking heads on CNBC a couple of hours apart and hear that the market is in the undervalued range since P/E is estimated between 13-16, whereas another will indicate P/E  in the 21-24 range suggesting a market top. Both commentators could be correct. (Of course, if you are a long term investor you may be more concerned about your asset allocation and annual saving/spending rate than P/E ratios.) I will try to give you a capsule version of their article, which you may wish to read in its entirety.

P/E or Price-to-Earnings ratio is used to value companies and markets. While the numerator, usually current Price (of one share), is known precisely, the denominator, Earnings (per share), is a lot trickier. Let’s look at various flavors of Earnings that may be used for the denominator.

Earnings may be based on:

1. Timeframe (past/known or future/estimated)

-known past data points, like: last calendar year, last 4 quarters or normalized earnings (average over a past multi-year business cycle, rather than just one year)

-estimated future earnings: next calendar year, next 4 quarters

-a combination of past and future estimated earnings, as would be a 2008 estimate in August

2. Type of earnings (operating and reported, and many other less common ones)

-operating earnings (higher), exclude the bad stuff (“one-off” write-offs)

-reported earnings (lower), including (some of) the bad stuff

So depending on whether the commentator is bullish or bearish (on a stock or the overall market) he may use a higher past actual or estimated future earnings number to lower the P/E ratio or a lower past actual or future estimated earning to raise the P/E ratio (remember that the Price is known).

Minter and Wiener point out that the long term (U.S.) market earnings are 6% (the sum of inflation and growth) and they always revert to 6%. So as the subtitle of the article states “The bearish view of earnings makes more sense), after a number of years of above average earnings one can expect lower than average (6%) years.

Of course you can look at P/E ratios in many markets around the world and make a judgment above or below allocation market cap based allocation in those markets based on P/E ratios, if you are so inclined. But you must also remember that only future (unknown) values of  earnings should be used in valuing a company/market since it is the future (not past, which though could be used as a starting point for forecasting) income stream that determines the current value. By the way Minter and Wiener think that “You could even lose a lot of money” in the market.

Alternately, you could just buy market cap weighted portfolio dictated by your risk tolerance (with perhaps an adjustment for where you expect to spend your money in the future (as indicated in my recent blog “A simple and cheap ETF based implementation of a balanced portfolio”. (By the way, this approach also does not guarantee that you won’t lose any money, but over the long term it appears to work at least based on historical evidence.)