This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Bob Leggett, senior portfolio advisor at Akron, Ohio-based ValMark Advisers, which markets the "TOPS" brand of asset allocation models.
Price-to-earnings multiples—the P/E ratio—of an equity investment is a core metric used by professional and amateur investors alike to value investments. To cut to the chase, P/E and similar valuation metrics must be fully understood to protect against misapplication and to enable investors to get the most out of them.
First, investors tend to focus on the “P” in P/E ratios.
When P/E ratios are higher than historical averages, we often see investors highlight that a price drop is imminent, as ratios will inevitably regress to the mean. While we do believe valuation tends to regress to the mean over time, we highlight that the regression may instead come from changes in the “E” in “P/E.” This lesson is equally applicable to ratios such as price/book, price/sales or even the dividend yield (dividend/price).
Secondly, we think it’s important to highlight the unreliable nature of many earnings numbers. Think figure skating or boxing matches that go to the judge’s cards, not speed skating or boxing knockouts that have an undeniable objectivity.
Misconceptions About Valuation Ratios
Reported corporate earnings per share (EPS) are the result of multiple executive decisions driven purposefully for their effect, as opposed to representing pristine measures of net income.
So it is that some of the metrics favored by investors and economists have their allure and limitations. Among those are:
- The 10-year Shiller P/E or cyclically adjusted P/E (CAPE) ratio
- Forward P/E (the P/E utilizing estimated earnings)
- Fundamental-weighting and factor-driven indicators
But before investors can fully appreciate why it is we currently own positions in a U.S. large-cap fund such as the iShares S&P 500 ETF (IVV | A-98), let’s look more closely at the limitations of various data like EPS and various valuation metrics.
With Or Without Makeup?
While we as portfolio managers are held accountable to independently calculated returns, companies have the ability to post their own scores. Within a range, company executives have significant flexibility on the EPS numbers they report each quarter.
The widely used consensus analyst “Street”—the number that is reported—EPS estimates are often based on company guidance and thus subject to the same adjustments.
The Associated Press (AP) recently released a study titled "AP Analysis: More 'Phony Numbers' in Reports as Stocks Rise." In the study, AP used data from S&P Capital IQ to review differences between adjusted profits and generally accepted account principles profits for 500 major companies.
In our opinion, some of the most interesting results included:
- 72 percent of the companies reviewed by AP had adjusted profits that were higher than net income in the first quarter of this year.
- One in every five companies exhibited adjusted profits higher than net income by 50 percent or more.
- From 2010 through 2014, adjusted profits for the S&P 500 came in $583 billion higher than net income.
- Fifteen companies with adjusted profits actually had bottom-line losses over the five years.
These findings should remind investors to take EPS reports and estimates with a grain of salt.
Recognizing that valuation is very important, we recommend using multiple metrics for asset allocation decisions. Although much of this discussion applies to international as well as U.S. markets, we will focus on domestic markets as we review a few popular valuation measures.