P/E Ratios Using Reported and Operating Earnings

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Includes: DIA, QQQ, SPY
by: David Enke

There is an interesting Barrons' article this weekend that highlights the difference between reported and operating earnings, including their overall effect on P/E ratios (which are used to make bull and bear cases). In a nutshell, operating earnings exclude write-offs, while reported earnings do not. In the past, the two were nearly the same for most companies, and certainly the market on average, but recently there has been a divergence given the level of housing and credit write-offs that companies are now taking. As reported in Barron's, with data from Comstock Partners:

Reported earnings for the S&P 500 for 2007 were just over $66. The operating earnings for 2007 were $84.54. The estimated numbers for 2008 are about $69 for reported earnings and about $90 for operating earnings.

This of course will affect your view of whether we are in a bull or bear market, or somewhere in-between. The article goes on to mention how:

If you are a bull, you will say that the market is trading at a very reasonable 16 multiple on the $89.44 of earnings in 2008 and 13 times the 2009 estimate of $110.44. On the other hand, if you are a bear or just a reasonable person you can see the market is trading at 24 times trailing earnings and about 21 times the estimate of 2008 reported earnings.

Given that markets tend to peak at P/E ratios around 20 and bottom at P/E ratios around 10, your earnings estimate, whether using operating or reported earnings, is important. Of additional interest is how earnings typically will only grow at about 6% per year over the long-term, a trend that reflects growth in real GDP plus inflation, with real GDP constrained on average by increases in the labor force and the level of productivity of those same labor force workers. When the earnings of the market rise above this 6% number, we see reversion to the mean. Given the current market multiples, it is expected that the market will not only go lower, but that it is likely to overshoot and fall below the 6% average trend line earnings, as it often does in corrections.

The old saying "Sell in May and Go Away" has not worked much in the last few years. Maybe this is the year we revert back to the actual mean ..... or meaning of the old saw.