Wry & Dry

Smoke & mirrors: How reliable is the 'E' in P/E?

W&D is a student of finance.  Which means attendance at lectures, not necessarily success at exams.  Nonethless, W&D senses 'the numbers don't add up'. 

The most widely used measure of whether a stock or stock-market is under-; fairly- or over-valued is P/E.  That is the Price divided by Earnings (i.e. profits, but using P for profits would give a formula of P/P, which is faintly ridiculous).  

The long-term average P/E for each of the Australian and US stock-markets is about 14.4.   The higher the P/E, the more expensive the stock or stock-market.

The P is easy to measure.  It's the share price of the stock, or, for a market, the market index e.g. S&P500 for the US market.

The problem is that there is no legal definition of E.

In the US, GAAP standards leave no room for interpretation.  But companies and analysts add or subtract numbers to create 'pro-forma' earnings, looking forward.  This is a complex matter, but sooner or later, the pro-forma adjusts to meet the GAAP. 

Gap

W&D's point is that over time share Prices follow Earnings.  A company's share price or market's-index will adjust to the reality of its profits.  Sooner or later.  But analysts are unfailingly optimistic: the above chart shows how wrong analysts in the US have been in forecasting actual E.

So, forward looking P/Es, in the US, are most likely based on an E that is too optimistic.  Hence, the E in P/E may be too high.  Hence, the P/E may be too low.  And hence the US market may seem more attractive than it actually is.  

As for Australia, better to sleep well and take a more conservative outlook to the E.