Why ETF Price/Earnings Ratios Lie

August 28, 2014

If I put China Fruit and J.P. Morgan into my portfolio, we could probably both agree that the P/E of the portfolio should be about 10. But how we come to that 10 is important. You could just make a weighted average of the two P/Es, giving J.P. Morgan 99.9 percent of the weight and China Fruit its tiny amount.

But what if instead of China Fruit, our two-stock portfolio had a company that was losing money?

According to Bloomberg (and a lot of financial data providers), no company in the world has a negative P/E. Not even Twitter, which, despite being a $29 billion company that loses $500 million a year, earns a negative P/E. Instead, it just gets an “N/A,” even though my 10-year-old can divide $29 billion by -$525 million and get -58.

So if you use Bloomberg’s P/E numbers and add Twitter to your J.P. Morgan stock, what’s your P/E going to look like? 10. And what if you add 1,000 other money-losing companies? 10.

It is, frankly, insane, and yet that’s the convention of many very smart companies and analysts. Not everyone just ignores negative P/Es, of course. Some assign artificially high P/Es to any company losing money. The point is that everyone does it differently. For a deep dive, check out our guide to negative P/Es written by Paul Britt in April.

So is there a “right” answer here? A rebuttal to the folks who thought Boris was an idiot? Sort of. In my opinion, how we do things here is about as not-bad as it gets. We take all the money earned by all the companies in a portfolio—positive and negative—and use that as the divisor against the total market cap of the portfolio (all weighted by the positions value in a portfolio, of course).

That way, the Twitters offset the J.P. Morgans, and you create a kind of “what if this was all one company” view of the real earning power of the entire pool of stocks, relative to how the market is valuing them.

It’s fine if you don’t like that way of comparing ETF stock portfolios. But whomever you lean on for data, the most important thing is to make sure you’re comparing two identical methods of calculation.

 


 

At the time of this writing, the author held no positions in the security mentioned. Contact Dave Nadig at [email protected] or follow him on Twitter (which he doesn’t own either) @DaveNadig.


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