Is P/E Busted?

(MSN) There is a simple way to improve the forecasting ability of the price-to-earnings ratio.

That’s good news because, despite perhaps being the most widely followed valuation indicator on Wall Street, the P/E ratio has a mediocre track record, at best. In fact, when tested on data back to 1871 from Yale University professor Robert Shiller, the P/E’s ability to forecast the S&P 500’s subsequent total real return is only barely statistically significant, regardless of whether one is focusing on the subsequent one-, five- or 10-year periods.

The modification that improves the P/E’s forecasting ability is to base its denominator — the “E” — on earnings in the best three of the trailing four calendar quarters.

That change, which an alert reader recently asked me to take a look at, was suggested last year in the Journal of Portfolio Management. Its authors are Thomas Philips, an adjunct engineering professor at New York University, and Adam Kobor, managing director of investments at NYU.

The motivation for their change is earnings’ extreme volatility from quarter to quarter, which causes the P/E ratio to itself be quite volatile and thereby reduces its ability to forecast the stock market’s long-term subsequent return. The authors suggest a modified P/E ratio in which the denominator is equal to the sum of the best three of the trailing four quarters — multiplied by 4/3 in order to make the altered denominator similar in magnitude.

This modification doesn’t always lead to major differences. Currently, for example, the S&P 500’s traditional P/E ratio is 28 versus 27.5 for the modified version. But sometimes there’s a huge difference. At the March 2009 bear market bottom, for example, the traditional P/E was over 100, while the modified version stood at 18.8.

Note carefully that the authors of this recent Journal of Portfolio Management article suggest other ways as well to improve on the P/E ratio’s track record, and interested readers should consult that article.

In the meantime, these results reinforce their conclusion that you can improve the P/E’s track record by ignoring the worst of the trailing four quarters’ earnings.


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