Comstock Partners, Inc.February 20, 2008
February 2008 - What is the Real P/E Ratio?
There has been a lot of discussion about the correct way to measure valuations in the stock market. Comstock, in fact, wrote a piece published in Barron’s magazine a few years ago about what we consider to be the correct way to measure under or over valuation of the stock market. We now see that the confusion is worse than ever, and we will try to help clarify the issue with this "special report" on valuation metrics and explain why we believe that the stock market is extremely overvalued and will continue to decline to much lower levels on the major indices. There is a section on our home page called "Limbo, Limbo—How Low Can It Go?" which we would encourage you to use to determine how low you think it can go by plugging in your own earnings estimate for 2008 and multiplying that number by the P/E ratio you expect the S&P 500 to sell at when the market reaches its low point or close to its low point.
If you watch and listen to the business news enough you must be getting very confused about whether the stock market is undervalued or overvalued. The bulls who appear on these financial shows assert that the stock market is inexpensive or cheap. They typically say, "This market is as cheap as it has been for the past 2 decades-- or the past 18 years". They could also state that the P/E ratio is below the norm over very long periods of time at 14-15 times earnings. Actually, their statements are correct, but they are accurate only because they are using debatable earnings.
At other times during the same day you may hear a bearish market maven try to convince the interviewer that the market is substantially overvalued and has a long way to go on the downside before it gets to fair valuation. The bearish interviewee will either discuss why the P/E ratio at over 20 times 2008 earnings estimates or 19 times the latest 12 months earnings are closer to valuations near market tops than market bottoms and that the market is therefore highly vulnerable. Believe it or not, these analysts are also correct.
If the bearish analyst really wanted to pursue a more sophisticated way of explaining the overvaluation, he or she may discuss why trendline earnings (or smoothed earnings) are the best way to measure valuation and using that method the market is extremely overvalued. (We will get into smoothed earnings at the end of this report—but right now we will keep this simple.)
The interviewer seldom if ever questions the disparity in the various market mavens approach to valuation. Let’s see if we can clear this up.
Essentially, few organizations are equipped to estimate the earnings of every company in the Standard and Poor’s 500 since it would require having analysts in every sector to study each individual stock and come up with the best guess possible. Because virtually no institution or money management firm does this themselves, we generally rely on organizations such as Standard & Poor’s to do the work for us.
If you go into the website at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS you will find a myriad of different earnings estimates from which you can choose. They show Reported Earnings, Operating Earnings, Core Earnings, Pension Interest Adjustment, and other earnings from which you can select. Rather than discuss all these different earnings numbers used by S&P, let’s just discuss the two main earnings numbers that Wall Street, in general, uses when discussing valuations. They either take the "reported earnings" or "operating earnings". Typically, the bulls use "operating earnings" and the bears use "reported earnings" because operating earnings are higher and reported earnings are lower. Also, it makes sense for the bears to use the last 12 months of earnings because they are usually lower and the bulls use forward operating earnings to help make their case. The only difference in the 2 main earnings estimates used is that operating earnings exclude "write-offs" while reported earnings include "write-offs". That is the only difference!!! If you scroll down to the early 1990s on the S&P website you will see that the earnings and PE on both operating and reported earnings were virtually the same. But then we entered the greatest financial mania of all time in the late 1990s (including many write-offs) and the earnings numbers diverged.
Generally Deceptive Accounting Practices
There were so many "write-offs" by companies making unwise investments that operating earnings grew much faster than reported earnings. We will get to what these earnings numbers are presently in the next paragraph. But now, let’s try to use some common sense in determining which of the two earnings numbers make the most sense. Do you think that using "operating earnings" which EXCLUDE "write-offs" are the more reasonable numbers to use or "reported earnings" which are GAAP (Generally Accepted Accounting Practices) approved? Comstock uses GAAP approved "reported earnings" because the "write offs" that were sporadic and unusual became common practice for many companies. Last year’s and this year’s Collateralized Debt Obligations (CDOs) are examples of poor investments that had to be "written off", and it’s hard to conceive of investors believing that these "write offs" should be excluded from earnings. Using "operating earnings" would be akin to playing in a major golf tournament that doesn’t count any penalty strokes for hitting the ball in a hazard or out of bounds.
Now let’s look at the numbers!! The "reported earnings" for 2007 were just under $73 while the "operating earnings" for 2007 were just over $84. The estimated numbers for 2008 are just under $100 for the "operating earnings" and just under $68 for the "reported earnings". By the way, these reported numbers have just recently been drastically revised downward due to the slowdown in the US economy. Now you can see why there is such discrepancy in the market mavens’ point of view. If you are a bull you will say the market is trading at a very reasonable 14 multiple on the $98 of earnings in 2008. On the other hand if you are a bear or just a reasonable person you can see the market is trading at 19 times trailing earnings and about 20 times 2008 "reported earnings".
Now, whether you agree with the bulls, or us, we suggest that you click on "Limbo, Limbo-How Low Can It Go" on our home page and plug in the numbers you believe to be the most logical. As you can see in the NDR (Ned Davis Research) 75 year chart most of the market peaks topped at around 20 times earnings (until the financial mania) and the troughs occurred at around 10 times earnings (also until the financial mania). You should concentrate on the bottom clip of these charts on historical P/Es, but notice NDR also uses the same earnings as S&P.
Regardless of the number you plug in, you now have to come up with the P/E number you expect to see at the market bottom. We would suggest you take a look at all the historical market bottoms on the charts and determine just how bad this bear market could be in relationship to the other bear markets. The bears might want to use a P/E number of 10 or below to multiply times the earnings expected, while the bulls might want to use today’s P/E or higher and multiply by the earnings they expect.
Smoothed or Trendline Earnings
Okay, this exercise has been fun and there is nothing wrong with the logic. However, if you really want to delve into an even better way of measuring valuation you should consider smoothed earnings. We will have to caution anyone who does not want to get a mind overload (which might require psychological help) to skip this section of the report. We will try to make this as simple as possible.
The best way to measure present earnings and future earnings is to smooth them out over long periods of time. The reason for this is that earnings can only grow at approximately 6% a year over the long term since it is limited by the growth in real GDP plus inflation—in other words, nominal GDP. Long term, real GDP cannot grow faster than the increase in the labor force plus productivity. Even if you don’t accept this premise, all you have to do is look at a long-term chart of earnings and draw a 6% growth line thru the earnings points and you will see how well it fits. When you have an earnings chart like the NDR chart attached, you can see the variations above and below the 6% line. Since, it is clear that the earnings sometimes rise above the line and sometimes fall below the line, it is clear that earnings will revert to the mean of the 6% line. When earnings are rising above the line it is usually because of an increase in the margins of a certain sector of the economy that is not sustainable and if they fall below the line, it is usually because of a recession or a credit crunch.
The main point we are attempting to make is that trendline earnings (or smoothed earnings) are actually a better measure of valuation than the actual reported earnings of the S&P or any other estimate. For long-term readers of Comstock you know we prefer to smooth the earnings of the S&P 500 with a 9-year average to accomplish an even more accurate way to evaluate true earnings over time. Attached is the latest chart of the smoothed earnings discussed in this report. You can see from the chart going back to 1950 that every instance where actual earnings rose above trendline earnings was followed by a period where actual earnings went well below trendline earnings. We believe we have entered such a period now. However, just as we would have advised you to use trendline earrings when actual earnings were above the trendline, we would continue to use trendline earnings when actual earnings fall below trendline earnings. Since trendline earnings are about $70 now, we would continue to use that number for all of 2008 (regardless of where actual earnings decline to in the recession) to multiply times the P/E you expect at the market bottom for valuation purposes. Since we expect the market to bottom at around 10 times earnings or less, the market has a long way to go on the downside if we are correct.