April 8, 2009
In his most recent posting on Yahoo! Finance, Jeremy Siegel reiterates his belief that Standard & Poor’s flawed earnings calculations for the S&P 500 are making the corporate earnings picture look much worse than it really is — and he says he thinks the market did indeed bottom on March 9.
According to Siegel, author of Stocks for the Long Run and professor of finance at the University of Pennsylvania’s Wharton School, S&P’s calculations are inaccurate because, while the firm uses a market-weighted average to determine the index’s returns, it does not do the same when figuring the index’s aggregate earnings.
“As a result,” Siegel writes, “the billions of dollars of losses racked up by, say, AIG, whose market value is extremely low, is added dollar for dollar to the earnings of the profitable firms, such as Exxon Mobil, whose market value is more than 20 times larger. … S&P’s methodology [gives] far too much influence to firms with big losses and low market values, and thereby gave a distorted valuation to the S&P 500 Index.”
S&P says reported earnings for the index for 2008 were just $14.97 per share, Siegel notes, which means the S&P 500 index was selling for a whopping 53.3 times earnings as of March 31, when it was valued at 798. Using Siegel’s market-weighted earnings method, the index’s reported per-share earnings would be $71.50, making for a P/E of just over 11.
Using operating earnings, S&P said earnings per share for the index were $49.49 in 2008, resulting in a 16 P/E ratio as of March 31, Siegel says. Using his method, operating earnings were $79.40 per share, making for a P/E of 10.
Siegel says S&P has countered his assertions by saying that the S&P 500 index is akin to a single company with 500 divisions; Siegel explains why he thinks that’s inaccurate — and why Robert Shiller, the noted Yale professor, thinks he has a good point.
One interesting point to keep in mind when evaluating the current market’s value: “Back in 2002 the aggregate earnings of the S&P 500 Index also plummeted when a few firms, such as AOL and JDS Uniphase, took huge writedowns on some of their Internet investments,” Siegel notes. “Reported P/E ratios soared into the 60s in the second quarter of 2002, yet rather than being overvalued, the market was just approaching its bear market low.”
Whether or not his earnings calculation theory is perfect, Siegel says the bottom line is that “the true valuation of the market is no where near as dismal as the aggregate earnings reported by Standard & Poor’s suggest. When portfolios of stocks are weighted by market values, the market is cheap by historical standards. No one can say for sure whether March 9 will mark the bottom of this dismal bear market (I personally think it will), but I am sure that investors who hold a diversified portfolio of stocks today will be rewarded by above-average returns.”
S&P uses simple sum because they’re SIMPLETONS!!!!!!
S&P, individual investors, guy working for the salary… we’re all in for a hard time at the moment:
http://iloveclosing.com/2009/04/10/why-i-won%e2%80%99t-get-out-of-bed-for-less-than-3-commission/
The Closer
I don’t understand how it matters how S&P calculates its earnings as long as it does it consistently through out the history of reporting for the index. More precisely if someone is looking at historical P/E ratio and get an average of this P/E ratio to compare it with current for valuation purposes wouldnt it be better if the earning reports were consistent? As long as these are consistently calculated, regardless of weighted or summed up, these will be useful from a simplified valuation perspective that uses average P/E ratio. For example, lets say S&P had historically used the weighted approach (which by the way makes more sense) then the resultant P/E history may suggest a certain average P/E lets say that came out around 20. Then investors valuaing markets would compare current ratios with this number. Since S&P did not report weighted earnings in reality… investors are using 15 for P/E average. The point is it does not make any difference in valuation methodology and resulting investing decisions as long as earning reports are consistently using a certain approach may that approach be flawed. There might be other reasons to use more accurate approach..my point is from a valuation perspective that uses PE ratios.
As long as every dollar lost by anyone, anywhere, anytime is replaced by a freshly minted “ObamaBuck” semantic arguments over price to “earnings” ratios are about as relevant as how much Nero paid for his fiddle.
It matters because a small number of companies may have a disproportionate impact on an average value. The rest of the companies may have consistent earnings, but if a couple of companies have huge losses this can have a large effect on the average.
It is a poor measure, so it does not matter if it is consistently applied. It does not supply the information it professes to, re: the overall value of the market. It should be disregarded.
The weighted measure is a better measure of overall market value. It is a shame that there is no way to compare it historically (that I am aware of), but you shouldn’t accept a poor measure simply because it is convenient.