According to an article in The Wall Street Journal, stocks are currently overvalued. First, the author compares the price-to-earnings (P/E) ratio of the S&P 500® index based on reported (i.e. net income) trailing twelve month (TTM) earnings to a 140-year median value. Then, the author admits that forward-looking, i.e. next twelve month (NTM), earnings estimates predict operating income that is higher than the net income, which suppresses the P/E ratio. To overcome this discrepancy, the author extends the average relation of the NTM P/E being lower than the TTM P/E by 24%, as observed from 1976 to 2003, to the entire 140-year historical period. (The 24% discount encompasses three factors: the predicted growth of earnings from TTM to NTM, difference between operating and reported earnings, and over-optimism in earnings forecasts.) This sleight of hand enables the author to conclude that in either case, stocks are currently overvalued by about 25% compared to a historical P/E median.

This mixing of reported and operating earnings, coupled with an arbitrary extension of a medium-term observation to a very-long-term historical period, leads to dubious conclusions.

Here is an alternative point of view from the July 22, 2013 edition of the S&P The Outlook:

From a fundamental perspective, S&P 500 valuations continue to look attractive. As of July 12, the S&P 500 is trading at 15.9 times trailing 12-month operating results, including the June 2013 EPS results projected by Capital IQ consensus estimates. This multiple represents an 11% discount to the median P/E of 17.8 times since Wall Street started looking at operating results in 1988. What’s more, the market is trading at a multiple of 15.2 times and 13.7 times trailing 12-month operating EPS for year-end 2013 and 2014 results, respectively.

Why does S&P look at operating results instead of reported earnings? Because of distortions caused by large, non-recurring, non-cash expenditures, and also by time misalignment of reported tax expenses with actual tax payments. Indeed, as the article’s title suggests, P/E ratios aren’t always what they seem.

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