The Investment U E-Letter: #349
Tuesday, June 29, 2004 The Truth About Earnings
By Dr. Steve Sjuggerud
President, Investment U The trick to pulling off a good lie must be that you believe the lie yourself… And when it comes to corporate earnings, brokers have come to believe their own lies. Today we'll consider the main measure of value in the stock market, what its true value is and what that tells us. We'll also take a look at how the brokers twist it into what they want it to say… Most importantly, I'll give you a concrete number that tells you what the current value of the stock market really is - plus how to use this information wisely. How Brokers Twist the Numbers Investors love to focus on earnings. The problem is, stock prices in relation to earnings right now are still above where they were before the stock market crash in 1929… Of course, a brokerage firm is not going to tell its customers that stocks today are more expensive than they were before the greatest stock market crash in history. No… they're in the business of pitching stocks. So they've got to come up with something… The price-to-earnings ratio (P/E ratio) is the standard gauge most people use to size up a stock's value. And the most widely used index of stock values is the S&P 500 Index (which is made up of 500 of the largest stocks in America). Are We at Another Pre-Crash Peak? Back at the market peak in 1929, the price-to-earnings ratio of the S&P 500 index was just above 20. As of Friday's close, the price-to-earnings ratio of the S&P 500 is 22. I got this number from the S&P 500 website (www.StandardandPoors.com). I find it funny that the brokers, knowing that stocks are overvalued, have subtly manipulated how they talk about the P/E ratio today… Standard and Poor's (S&P) reports the P/E ratio based on what companies have actually reported for earnings… S&P calls this "as reported" earnings… I consider it to be business that's "in the door" - earnings already made. It's the "good" number. Strangely, the brokerage firms somehow report a P/E ratio of the market of 16 or 17… how do they come up with this fake number? The first trick the brokerage firms came up with a few years ago was to report on "estimated" earnings… earnings a company hasn't made yet, but Wall Street analysts expect they'll be able to make sometime down the road. It was a good trick… it had an air of believability to it… and seemed to justify their research. Unfortunately, the "estimated earnings" number doesn't help the brokers much now… For example, the P/E of the S&P 500 Index, based on broker's guesses for the end of the year 2005 (a pretty good way off), only brings down the market's estimated 2005 P/E to 19. So the brokers needed to come up with a new trick… The new trick is looking at "operating" earnings instead of sticking with tradition and looking at "the bottom line" earnings. To be legitimate, brokers should call this the P/OE ratio, not the P/E ratio. They don't. Any Way You Cut It, This Market's Overvalued Now the brokerage firms are in a pickle again, as the current P/OE is around 19. The number is not low enough for the brokers to justify buying stocks… So it's time to invent yet another number… How about the P/OE based on broker's future guesses of operating earnings for year-end 2005? That's what they use today, as it gets the market P/OE down to 16. Of course, to properly show it, they should call it what it is… YE2005Est. P/OE ratio This creates another problem, as everyone knows the term "P/E" (price/earnings ratio), but most people aren't readily familiar with what the "YE2005est. P/OE ratio" tells you. That's perfect for the brokers… as the number has an air of legitimacy, but it's still goofy enough to confuse most people, and doesn't have much of a track record. The brokerage firms can continue to believe their own lies and pitch you stocks. When the old lies don't work, it's time to come up with a new one. The honest P/E number, as calculated by Standard & Poor's, shows that stocks today are more expensive right now than they were at the last two stock market peaks, 1929 and the late 1960s. I'm sure you're aware that if you had invested during either of those times (1929 and the late 1960s, when the P/E was around 20), you wouldn't have broken even in stocks for well over a decade. You can listen to the brokers, and how they say stocks aren't expensive. But they are. So plan accordingly. Today's IU Cribsheet Good investing, Steve Related Articles: Investment U Archives | 
