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Value investors rely on the Price Earnings Ratio. But what is it? And How do you really use it? What is the difference between GAAP earnings and Operating Earnings?
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The Historical P/E Ratio and RealityBy Lynn Carpenter As a value investor, the very first thing I learned was to compare the stock price to its earnings per share. That’s the famous P/E ratio we value investors love to use. Like everyone, I learned that the historical P/E ratio for U.S. stocks was 15. Stocks over that were overvalued, below that were undervalued. Eventually, I expanded “normal” to 18 for really good companies. Every earnings season is interesting to value investors because the newest numbers change the P/E ratios. The quoted ratio is based on the current price divided by the past four quarters’ of earnings. Maybe that stock that was too rich at a P/E of 30, has such good numbers its only a P/E of 19 now… Still what I learned was wrong. Dead wrong. If you look at a chart of historical P/E ratios, you will see that the market is often above or below 15—but it’s hardly ever at 15. The value of 15 is an average, not an actual station. Very misleading… If you average all the 15-pound dachshunds and all the 75-pound labs in your city, you will get a 45-pound dog. And not a one of them would be a 45-pound dachshund. In addition to that faulty concept, there’s a “they say” mistake here. Somebody said the average was 15, somebody repeated it, soon everybody “knew” it. But Ned Davis research actually puts the S&P 500’s average P/E at 17.6 for the past 50 years. The 25-year average is 20.7. To make matters worse “earnings” come in various flavors. Reported earnings follow GAAP (generally accepted accounting principles). They include write-offs. “Operating” earnings don’t. The difference can be substantial. The averages I just quoted were for reported (GAAP) earnings. The operating earnings averaged lower: 17.9 for the past 25 years and 16.2 for the past 50 years. The difference is widening lately with the credit crises and so many financial companies in difficulty. In 2007, operating earnings (which excluded the write-downs) were about 15% higher than reported earnings. And for 2008, Ned Davis expects that gap to rise to 44%, the biggest difference ever. Headlines will probably feature operating earnings to avoid calling attention to the deadly effect of large write-offs this quarter. But you are armed now that you know the difference. Get ready for the season. This investment news is brought to you by Investor’s Daily Edge. Investor’s Daily Edge is a free daily investment newsletter that is delivered by email before the market opens. It’s published by Fourth Avenue Financial, a subsidiary of Early To Rise (an affiliate company of Agora Publishing). In each weekday issue you’ll receive practical strategies for protecting your portfolio and multiplying your money. You’ll also learn about undiscovered opportunities in emerging sectors and markets, deeply discounted stocks, recommendations for bonds, cash, commodity and real estate investing, and top ETFs. To view archives or subscribe, visit Investor's Daily Edge.
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