The article critically examines the use of the market P/E multiple, particularly when based on aggregated forward operating earnings estimates, labeling it a "price-to-fantasy ratio." It highlights a fundamental flaw in combining individual stock operating earnings estimates to form a collective market earnings estimate. Operating earnings, which exclude non-recurring or extraordinary items, tend to be significantly higher than reported earnings. Data from S&P shows that aggregate S&P 500 reported earnings over the past 34 years have been 13% lower than collective operating earnings, with this gap widening notably during recessions. Analysts' estimates for individual stocks typically use operating earnings, but aggregating these at the market level overlooks the inevitable drag from negative extraordinary items that are not factored into future projections. This leads to an inflated view of earnings and a lower, more attractive P/E ratio.
Such an aggregated P/E ratio tacitly assumes no future negative extraordinary items, which is unrealistic. The article points out that companies often exclude more negative extraordinary items than positive ones when reporting operating earnings, leading to what some describe as "earnings before whatever went wrong." For example, in 2020, operating earnings for the S&P 500 were 30% higher than reported earnings, and in 2008, the difference was 233%. This discrepancy becomes particularly extreme during recessions.
The article provides concrete examples of how this aggregation fallacy can skew valuations. S&P's aggregate of analysts' estimates for 2023 operating earnings is $226, representing a 13% growth over 2022, which translates to a P/E multiple of 17 times. However, if actual reported earnings for 2022 merely matched $181, the current forward P/E would be 21. If reported earnings for 2022 were to decline just 20% from 2022 levels (a less severe drop than an average recession), the P/E ratio would jump to 26, suggesting the market is far from a bargain. After the outbreak of Covid-19, reported aggregate earnings fell to $94 per share, rebounded to $198 in 2021, and were expected to drop 9% to $181 in 2022. Operating earnings consistently exceeded reported earnings during this period, being 30% higher in 2020, 5% higher in 2021, and an estimated 10% higher in 2022.
