Will the real P/E ratio please stand up?

By Mark Hulbert

The monthly review of stock market valuation indicators

There's no single P/E ratio, causing no end of confusion.

The reason there's more than one ratio traces to ambiguity about the denominator. While the numerator is a fact of the matter, the denominator can be any of several different values. If we focus on trailing 12-month "as reported" earnings per share, for example, the S&P 500's SPX current P/E is 22.3. If we instead focus on analyst estimates of "operating" EPS over the next 12 months, the P/E is 17.9--20% lower. And that's just two of the possible P/Es.

Perhaps the most important thing to keep in mind is that consistency is a virtue. If you are focusing on the P/E based on estimated next 12-month earnings, for example, you need to compare it to historical values of a similarly-calculated P/E. What you don't want to do is compare a current forward P/E with past values of the trailing P/E.

That's because, almost without fail, forward earnings estimates are higher than trailing actual earnings, which means that the forward P/E will most of the time be lower than the trailing P/E. An artificially low P/E, of course, will lead you to conclude that the market is more undervalued (less overvalued) than it really is.

There are two main reasons why forward earnings estimates are higher than trailing actual earnings. One is that the economy in general, and corporate profits in particular, tend to grow over time. The second is that Wall Street analysts are inveterate optimists.

To illustrate their optimism, consider that a year ago the Wall Street consensus was that the S&P 500's operating earnings per share for calendar 2023 would total $238.54, according to data from Howard Silverblatt at S&P Global. The latest estimate is that it will be $218.71, 8% less. And it's a good bet that the actual total for the year will be lower still.

P/E ratios based on trailing 12-month earnings don't suffer from analyst optimism. But they have a different problem: They will be way too high at the bottom of recessions. That's because earnings at that point will be especially depressed, relative to what they will be when the economy recovers.

This is well illustrated in the accompanying chart, which plots since 1999 both the trailing 12-month P/E and the forward 12-month P/E for the S&P 500. In almost all months since then the trailing P/E is lower, except at the bottoms of the recessions in 2002 and 2009.

Which P/E is better?

The proof of the pudding is in the eating, of course, so I measured their ability to forecast the S&P 500's return over the subsequent 12 months. The forward P/E ratio comes out significantly ahead, at least based on data since 1999. (I was unable to get historical data on the forward P/E prior to then.) But this result traces to the artificially high trailing-12-month P/Es at the bottom of a downturn. Upon bracketing the 2008-2009 bear market, I found that the two P/E ratios have nearly identical records when predicting the market's subsequent one-year return.

Even better than these two P/E ratios, however, is the Cyclically Adjusted P/E ratio, or CAPE, which was made famous by Yale University's Robert Shiller. Because the denominator of the CAPE is trailing-10-year inflation-adjusted earnings per share, the CAPE smooths out the cyclical gyrations in earnings per share. And in a horse race between the CAPE, the trailing 12-month P/E, and the forward 12-month P/E, the CAPE comes out far ahead.

How valuation models stack up currently

I have decided to add the forward 12-month P/E to the list of valuation indicators that I report each month in this space. That's not because the forward P/E has a superior track record than the other eight that I previously have featured. But since it's just as good as the trailing 12-month P/E, especially at the bottom of recessions, it deserves to be mentioned.

In any case, the valuation story forward P/E is currently telling is of an overvalued stock market. This is broadly similar to the stories told by the other indicators as well.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

-Mark Hulbert

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10-23-23 1322ET

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