The Pros and Cons of Different P/Es

When it comes to valuation metrics, Charles Schwab Chief Investment Strategist Liz Ann Sonders says beauty is in the eye of the beholder, and in recent commentary she reviews how a number of price/earnings ratios can give varying views of the market.

“Ask a bear about valuation and he’ll likely say the market is very expensive. Ask a bull about valuation and he’ll likely say the market is quite cheap. What gives?” Sonders says.  “Assuming by ‘valuation,’ you mean price-to-earnings (P/E) ratio, the answer is in the eye of the beholder, and/or a function of the denominator (E, or earnings) you opt to plug in.”

One type of P/E of which Sonders is wary is the 10-year cyclically adjusted P/E used by Yale economist Robert Shiller, which currently shows the market to be significantly overvalued compared to its historical average. The metric averages earnings over the past 10 years and adjusts them for inflation to even out cyclical fluctuations or short-term anomalies. But Sonders says a key problem with it is that the typical U.S. business cycle, encompassing an expansion and recession, lasts about six years, not 10 years. Looking at 10 years of earnings thus doesn’t give a true sense of how earnings were over a full business cycle. Sonders also says there are problems with the way the 10-year P/E factors in inflation, and she notes that accounting standards have changed dramatically over the past several decades, which makes many of the earlier 10-year P/E readings (which go back to the 1800s) a poor comparison to today’s readings.

Sonders also talks about P/E ratios that look at shorter time frames, like the trailing 12-month P/E and the forward P/E, both of which are showing the market to be undervalued. These metrics have some problems, too, however, she says. For example, the forward P/E, which looks at projected earnings over the next 12 months, relies on the “notoriously bad forecasting ability of the analyst community” to project earnings for the next 12 months.

Sonders says that one of her favorite P/E metrics is the five-year normalized P/E, which was created by Steve Leuthold. This uses earnings from the past four-and-a-half years along with the next two quarters of projected earnings. It currently shows the stock market to be valued slightly above its historical average, though it is below the average for periods in which inflation has been at its current low level.

The bottom line, Sonders says, is that you can likely find a P/E ratio that will support any view of the market. But, on the whole, she is still bullish. And, she offers one final key point: Don’t use any valuation metric or any indicator as a market-timing tool.