The Folly of Focusing on Operating Earnings

Aug. 3.09 | About: SPDR S&P (SPY)

S&P 500 Earnings Per Share: $1

Well, $1.27 actually.

These are the reported earnings per share from Standard & Poor's for the S&P 500 index. The last two quarters of 2008 and the first quarter of 2009 are actual earnings. The second quarter of this year is comprised of roughly half reported earnings and half expected earnings from companies yet to report.

Q2 09 $7.52 (53% of companies reporting)

Q1 09 -$23.25

Q4 08 $9.73

Q3 08 $12.86

Total $1.27

Hands up for all the sharpest minds on Wall Street who forecasted $1 per share in earnings.

It actually gets worse for the third quarter when S&P expects the index to generate its first 12 month loss ever. If analysts are correct for the rest of this quarter and for next quarter, the index will generate a loss of $1 per share.

Of course, this does not really matter much in regards to the current market environment. Current trailing earnings grossly underestimates the structural profitability of corporate America.

But here is the thing - Wall Street continuously overestimates the structural profitability of corporate America.

The long-term average profit margin for the S&P 500 has been 5.6%. But Wall Street does not focus on reported earnings. It focuses on operating earnings. We have discussed the folly of focusing on operating earnings, and the past year brutally demonstrates why. The profit margin before extraordinary charges, i.e. "operating earnings," has averaged 6.6%. In other words, Wall Street's best and brightest have over-estimated corporate profitability by a whopping 1%.

click to enlarge

Operating v reported profits 09 07

On average, Wall Street has over-estimated actual quarterly earnings per share by using operating earnings by 20%. 20%! Even excluding the enormous write-offs generated in the financial sector, operating earnings have on average been 15% higher than reported earnings.

Using $1.27 for a P/E ratio is meaningless. The market's structural profitability in no way implies a price/earnings ratio of 777x.

A better way is to use operating earnings and taking a 15% or 20% haircut to get a more accurate assessment of true valuation.

For the next 12 months (NTM), analysts are expecting the S&P 500 to earn $65.38, and $74.01 for 2010. Lop 15% off those numbers and you come up with $55.57 and $62.90 respectively. With the S&P closing at 987.48 on Friday, the market is trading at 17.8x NTM earnings and 15.7x 2010 earnings. Considering that the long-term average trailing multiple has been 15x and the long-term forward multiple has been 14x, this would imply the market is expensive.

I prefer to use a multiple of normalized earnings. Last time I checked, sales per share for the S&P 500 over the last 12 months was $929.75. Over the long-term, the reported earnings margin has averaged 5.6%. Using this number, normalized earnings would be $52.07, and the market would be trading at 19.0x earnings. Using the long-term average margin of operating earnings, 6.6%, normalized earnings would be $61.36, and the market is trading at 16.1x earnings. I use a 7% normalized margin because I believe corporations are structurally more profitable than in the past. Thus, my normalized earnings are $65.08 and the market is trading at 15.2x.

Any way you cut it, the market is no longer cheap, especially given that the economy is going to be lackluster at best for some time to come.