Start Looking Forward to Earnings Season

Earnings season officially kicked off on Monday with Alcoa’s (AA) $1.49/share loss versus last year’s $0.75/share profit in the same quarter. The market yawned at the news and share only moved 0.5% in aftermarket trading. We all know that earnings this quarter will be dismal. In fact, Thompson Reuters expects negative earnings growth in seven of 10 sectors it tracks.

How could Alcoa investors shrug off such poor earnings? Alcoa’s all-important P/E ratio is about to rocket out of control with its shrinking earnings, right? If this trend continues, all the pundits that have been claiming that the S&P 500 P/E ratio is reaching historically low levels must be wrong! The market will become overvalued in just a few days as more earnings falter.

Not so fast. The P/E ratio in basic quotes provided by many financial sites - Google Finance, Bigcharts.com, etc. - is typically based on rolling 52-week earnings. That is, most P/E numbers you see are a trailing metric. Not only that, but also, these earnings numbers are not “cleaned” for extraordinary or one-time events.

Case Study
Here’s an example of current P/E valuations for a few major credit card companies. I’m using readily attainable data from Yahoo!Finance.

Taking trailing P/E in a vacuum, you might come to the decision that MasterCard (MA) and Visa (V) must be trading at unreasonable premiums. MasterCard is trading at $148/share despite having no earnings, and you’d be paying a whopping $91 for a beneficial ownership in every $1 of Visa earnings. American Express (AXP) and Discover (DFS) look like much better “values.”

In reality, Visa and Mastercard have been hit by the settlement of two lawsuits, which forced them to make large one-time payments which affected their earnings over the last year. In the future, you’re not likely see them have to make these payments and as a result, they ought to very quickly return to higher earnings levels in the future.

If we look at valuations based on estimated next year’s earnings, this is exactly what we see. In fact, on a forward basis, the four major credit card processors are trading within a very close range. While AXP and DFS still look like the best “values,” it’s now not as clear-cut. It can be argued that the premium on MA and V shares is reasonable since they operate solely as payment processors. Discover and American Express, on the other hand, are exposed to consumer credit since they operate as lenders in addition to offering payment processing. Given headwinds around consumer credit , there would seem to be more risk to forward projections on American Express and Discover earnings.

Don’t get me wrong, forward P/E does have its faults. It’s based on consensus estimates from Wall Street analysts and we all learned during the dot-com bubble that their estimates are not always conservative. In fact, if you have the wherewithal I suggest constructing run-rate earnings numbers on your own. Particularly in a recessionary environment, I believe that on-going earnings will be better represented by forward P/Es than trailing P/Es.

Full disclosure: No positions in any of the stocks mentioned.

Comments

[Ishortyou:]

Forward P/Es seem to be a reasonable way to get some feeling about investing, trail P/Es might not be that appealing, but who is providing this forward P/E information on stocks?

Jan 13 09:53 AM

[The Curious...:]

A good point indeed. Forward P/E is only as reliable as the source of the forward estimate. Truth be told, to get a good apples-to-apples number, you should develop your own methodology for cleaning an earnings number and projecting forward. That way, you know you are getting a consistently calculated earnings number.

If it wasn't obvious, I found my forward P/E numbers using Yahoo! Finance. The forward earnings number used is Yahoo's average analyst estimate for the next four quarters. I believe the source data from this is from Thomson Financial which aggregates estimates from various sell-side research.

Jan 13 04:30 PM