The price-to-earnings ratio is a common valuation ratio derived by dividing the price per share of an individual stock or stock index by its earnings per share. There are several measures of earnings that can be used in the calculation, all with their own benefits and drawbacks. The most common version of the ratio relies on the most recent 12-months of reported headline earnings. This measure has the benefit of being based on audited results, making it more reliable and consistent over time, however, the potential volatility in earnings resulting from non-recurring one-off charges makes it less relevant for an individual stock or for stocks in general during a recession. As a result, investors may use forward estimates of operating earnings over the next 12 months. This approach has the benefit of factoring in anticipated earnings growth, but numbers will be misleading at inflection points in the profit cycle. A third common measure of earnings involves a cyclical-adjustment made by taking inflation-adjusted earnings over the prior ten years (the price is also inflation-adjusted in this version of the ratio). This measure was developed by Robert Shiller and introduced during the Dot-Com bubble when it was cited as evidence that the stock market was overvalued. The adjustment to earnings results in a far more stable and slow-moving denominator, which smooths out the cyclicality in margins and profits over time. While imperfect, the Shiller P/E has the benefit of the highest correlation (inverse) with future realized long-term returns.
The chart below shows the spread between two of these ratios — the Shiller (cyclically-adjusted) and reported P/E — over time. The spread today is approximately 9x, reflecting a Shiller P/E of 31.1x less a reported P/E of 22.2x. Historically, spikes in this spread have coincided with temporary and unsustainable spikes in profit margins, making stocks appear cheaper than they are. These episodes have also often marked the peak of profits cycles and bull markets. While there have been notable false positives from this signal, most notably in the mid to late 1990s, we believe investors should at least consider the sustainability of corporate profit margins in the coming years.
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