Chapter 3. Don't Shoot the Messenger
How the Story Ends
One has to be very careful with the "E" in the P/E equation. There are usually no qualms about the "P"—it is what it is. The S&P 500 is trading at 1,122.8 as I am typing this in August 2010; that is the "P." But the "E" is a whole different animal.
"E" often requires normalization, as earnings are impacted tremendously by where we are in the economic cycle at a given time. Blindly using "E" without normalization will lead you to the wrong conclusions when you analyze the stock market and individual stocks. In Exhibit 3.1, P/Es for past market cycles are computed based on 12-month trailing earnings; however, I used 2010 estimated earnings to demonstrate current market valuation. Here is the rub: Estimates for 2010 reported and operating earnings for the S&P 500 are $75 and $45, respectively. A significant difference between two numbers is the "one-time" charges that never end up being one-time. I arrived at my "E" of $60 by averaging these two numbers.
Figure 3.1. Starting and Ending P/Es Based on 1-Year Trailing (Reported) Earnings of S&P 500
However, a better way to deal with the volatility of "E" in the P/E equation, when we attempt to value the market is to use 10-year trailing earnings. We use the current "P" but then average earnings over the preceding 10-year period. Don't worry, I won't ask you to compute the average (free ...