Beyond Diversification: What Every Investor Needs to Know About Asset Allocation

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Valuation and Something About Kool-Aid

To which earnings (E) should we apply the P/E ratio? Valuation should be based on future earnings, not current earnings.

—JPP

FOR STOCKS, THE NEXT STEP IS TO REFINE OUR EARNINGS forecasts. Then we can decompose expected returns into more detailed building blocks. When I estimated the equity market risk premium as an input to the CAPM, I showed that the simplest way to forecast equity returns based on valuation is to invert the price-to-earnings ratio. We divide 1 by the quoted P/E number, et voilà, we have a reasonable long-term return forecast. But in finance, especially when we try to forecast returns, nothing is ever that simple. I introduced the battle of the professors between Siegel and Shiller, ...