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Stock Ideas Investors Daily Edge About that Historical P/E Ratio and Today’s News
Stock Ideas Investors Daily Edge About that Historical P/E Ratio and Today’s News 
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| About that Historical P/E Ratio and Today’s News |
| Thursday, 11 September 2008 | ||||||||
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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. And remember that operating versus reported earnings divide? 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.
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