A trader works on the floor of the New York Stock Exchange
Aggregate forward earnings estimates will tacitly assume no future drag from the inevitable extraordinary items that overwhelmingly tend to be negative © Michael M Santiago/Getty Images

The writer is chief executive and chief investment officer of Research Affiliates

Too much financial commentary perpetuates an error when applying the yardstick of a market’s collective price to aggregate earnings.

The forward price-to-earnings ratio is perhaps the most common valuation tool around for good reason. Typically based on the consensus of forecasts for earnings for the coming 12 months, the ratio is intuitive and can be compared across markets, sectors and history.

But often the cited metric is one based on a fallacy and it is one that becomes extreme during a recession, which seems more likely than not this year. The error occurs when aggregating analysts’ estimates of future operating earnings for individual stocks into the broader market p/e multiple.

Such calculations are based on a quite sensible initial assumption. The more relevant measure for investors of earnings for individual stocks is expected operating earnings. That is earnings excluding non-recurring, extraordinary items in the profit and loss account and contributions from discontinued operations that will not be part of future earnings. Extraordinary items can be positive or negative and could include anything from the cost of lay-offs to a profit on an asset disposals.

Thus, analysts quote a stock’s p/e, using forecast operating earnings for the next quarter or next year. The fallacy emerges when market strategists aggregate analysts’ estimates for individual stocks into a collective market earnings estimate and forward p/e ratios. Why?

Companies choose to exclude far more negative extraordinary items than positive, leading some to describe operating earnings as “earnings before whatever went wrong”.

Of course, strategists presumably know that every year some companies will disclose unexpected declines in earnings, including some truly awful losses, depressing those companies’ and aggregate market reported earnings. It is almost impossible, however, to know which specific companies will do so in any future year.

This means that aggregate forward earnings estimates will tacitly assume no future drag from the inevitable extraordinary items that overwhelmingly tend to be negative.

Data provided by S&P show that aggregate S&P 500 reported earnings over the past 34 years have been 13 per cent lower than collective operating earnings. And as noted earlier, this gap widens markedly during recessions.

In 2001 and 2002, the market’s operating earnings — using the S&P 500 index companies as our proxy — exceeded reported profits by 57 per cent and 70 per cent, respectively. In 2008, the difference was 233 per cent and in 2020, it was 30 per cent.

After the outbreak of Covid-19, reported aggregate earnings fell to a deeply depressed $94 per share, rebounding in 2021 to $198. For 2022, this expected to drop 9 per cent to $181. Operating earnings — not surprisingly — exceeded as reported earnings for all of these past three years, coming in 30 per cent high in 2020, 5 per cent high in 2021, and probably 10 per cent high in 2022.

Near the middle of this year, all companies in the S&P 500 will have published their 2022 financial statements. By then, aggregate as reported earnings will probably fall below today’s estimate. When those final as reported numbers become available, 2022 earnings for the S&P 500 will probably have declined more than 10 per cent relative to 2021. Nobody will notice or care.

Strategists now focus their attention on earnings estimates for 2023. Once again these wildly optimistic estimates of market earnings growth ignore all the “non-recurring” losses many companies will report this year.

So S&P reports the aggregate of analysts’ estimates of operating earnings for 2023 at $226, 13 per cent growth over 2022. That translates into a current market forward p/e multiple for the S&P 500 of 17 times.

But if we assume the actual reported earnings for the S&P 500 this year merely match the estimated 2022 level of $181, then the current price-to-forward earnings ratio is 21.

If we have a recession, as many now expect, S&P 500 earnings may well tumble. If as reported earnings for this year decline just 20 per cent from 2022 levels (much less than an average recession), then the current ratio is 26, hardly a bargain.

This is why we refer to the market p/e multiple based on aggregation of individual stocks’ forward operating earnings estimates as the price-to-fantasy ratio.

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