Hi friends. Well, I read something yesterday that made me do a double-take. Go here to see what I read from Reuters.
Most large companies report something called non-GAAP (generally accepted accounting principles) earnings each accounting period, in addition to GAAP earnings. Go here to read a thorough piece on the problems with non-GAAP earnings. Investors and analysts base valuation on non-GAAP earnings. This practice of adjusting true GAAP earnings to non-GAAP earnings results in an inflated earnings number frequently. Occasionally, the adjustment process lowers the non-GAAP earnings from the GAAP number, but it’s not the case very often.
This Reuters piece aptly notes that the overall market’s price to earnings (P/E) is based on non-GAAP earnings figures. Since non-GAAP numbers are usually elevated from GAAP earnings due to exclusion of so-called non-recurring income items, it’s worth noting that the market’s P/E would be higher if GAAP numbers were strictly used by the market in its analysis of central operating performance. That is, the market’s lofty P/E we read about today is actually higher in reality.
Now, there are indeed genuine one-time events that impact the earnings of an accounting period and when they happen, investors should know that this impact should be excluded from future expectations toward earnings. However, when non-recurring events continue to occur quarter after quarter, that’s not really non-recurring.
This Reuters article says that non-recurring effects are becoming lesser on GAAP earnings than they used to be (It seems a little pressure from the SEC can go a substantial way in changing corporate managers’ reporting behavior). The article goes on to basically conclude, “hey, this is a good thing because the S&P 500 P/E of almost 18, on a relative basis, is really not as high as it seems because a P/E of 18 in the past would have actually been higher” (this quote is actually my paraphrase wording of what I read). From that thought process, the article extracts that stock prices are not as relatively high as they used to be, assuming a P/E of 18; that this shift in reporting is good for stock prices.
Well, after reading the article, I found myself shaking my head a bit at the emphasis on stock prices. While the author did not say this, it almost sounded like a reader’s intended takeaway might be that overall stock prices aren’t as high as they seem. And while I see the logic, it remains that if one believes a stock price of $18 to each dollar of earnings is high (assumes an 18 percent forward annualized growth rate in corporate earnings), then it’s high. And, if the 18 number is not based on earnings that actually reflect corporate continuing operations but rather based on overstated earnings (by excluding some negative things that may really represent recurring items), it’s really high, is it not?
So, doing some pondering following my “say what?”moment, I concur that it’s good that companies are not excluding as many “recurring” items as they were in the past to derive non-GAAP earnings. To exclude things that should be included is false reporting. But, simply put, until the earnings number has culled out all elements of overstatement relative to establishing future expectations of operating performance, the news is that the P/E of almost 18 is still understated. Also, unless one believes the market can grow at an annualized 18 percent clip, how can this lofty, yet understated P/E be maintained?
In summation, my take about the non-GAAP earnings number getting closer to the real recurring GAAP number is that it is very good that the market is working with better operating financial data than before. After all, analysis of numbers leads to decisions and it follows that those decisions are no better than the numbers behind them. Further, my take from the article is that the 18 P/E is still artificially understated, even though not as much as in the past. The improvement in non-GAAP reporting due to regulatory pressure implies that management, left unchecked, will manipulate the earnings out of self-interest toward achieving greater personal rewards via things like bonuses and stock option awards (that are tied to earnings). Finally, the article implicitly emphasizes the need for stabilizing financial information given the gap between GAAP and non-GAAP reporting of earnings. In a significant way, the balance sheet provides an anchor, a backdrop if you will, of worth as it can serve to support the ultra conservatism needed to offset unbridled optimism when investing in common stocks. My book,”Choose Stocks Wisely,” shows how to employ the balance sheet in a practical manner.
See you next time.
Thank you Dr. Allen for your article. Would you expand on your comment about the P/E number being equal to the assumed earnings growth rate? How does the math work regarding this assumption? Thank you.
Hey David. Well, let’s say you buy a stock share for $10 that earned $1 last year. Therefore, the P/E is 10 and the rate of return is 10%. Ignoring dividends for simplicity (what I’m explaining remains a truism even if dividends are considered, just a bit more involved to explain), for you to realize that 10% rate of return, the stock price needs to advance to $11 per share (10 x 1.10 = 11). But for the P/E to remain 10, the earnings must advance next year by 10% as well ($1 x 1.10 = $1.10 and $11/$1.10 = 10)….and so on as succeeding years pass by. So, the only way for the stock price to justify a P/E of 10 today (to be fairly priced) is for the expected future earnings to grow annually by 10%; if the earnings don’t keep advancing by 10% each year, how can the stock price be expected to keep growing by 10% each year?
For more reading, read about the PEG ratio,the P/E to G(rowth). It follows the logic above and therefore says a fair price today is where the P/E equals the expected annualized future growth rate in earnings expressed as a whole number (so, an expected growth rate of 18% would be used simply as 18 in the PEG formula. If the P/E is 18 and the expected growth rate is 18,the PEG is 1.00 (18/18 = 1.00). That is, a PEG equal to 1 is a proxy for a fairly valued stock. When the PEG is less than 1 because the expected growth rate in earnings is greater than the P/E,some use this approach to define an undervalued stock. If the PEG is over 1 because the expected growth rate is less than the P/E today, we can say the stock very well may be overpriced.
Here’s something to read on PEG.
https://www.gurufocus.com/news/182271/peter-lynch-fair-value–value-companies-with-peter-lynchs-simple-rule-of-thumb
If you do a search on PEG ratio, you will find many good references on the matter.
Finally, David, it’s my opinion that today’s P/E of 18 is lofty with regard to how fast earnings need to grow going forward to justify this P/E. The author of the Reuters article uses the incremental closing of the gap between non-GAAP and GAAP earnings as good for stock prices since the 18 P/E now would have really been even more understated in the past than it is today. However, that’s a super optimistic take in my view with regard to stock prices right now. While it’s good that GAAP earnings are being applied more today in reporting of periodic operations, my takeaway from the information in the article is that 18 is still high, it’s still understated relative to using pure GAAP earnings, and it makes me concerned about the whether we are being realistic toward future growth expectations. If we aren’t, the market will correct it eventually as it always does.
Hope this helps explain.
Thank you for your in-depth reply, Dr. Allen.
Dr. Allen,
I’d like to take this valuation discussion a little farther. So just for discussion I’d like to share some thoughts I’ve had relative to this post. I had the thought that the nominal return of the market over time has been about 10%. And the market’s real inflation adjusted return has been about 7%. So it seems that the fair value of the market over time would be a ten multiple, and history has shown that buying at a market multiple of 7 or 8 has been a profitable act for a long term investor. But historically the market has traded at about an average 15 or 14 multiple and anytime it gets above that one starts hearing about the market being overvalued and below that one starts hearing talk of an undervalued market. But a 14 multiple is 40% above a 10 multiple.
These data points lead me to ask if this 40% premium is in any way related to the Equity Risk Premium which is the difference in the ten year note yield and the earning yield of the market (or SP500 as a proxy)? Or can this premium be considered nothing more than the positive avg sentiment market participants have had relative to the actual value?
Julian,
That’s an interesting question. First, let me refer you to Investopedia’s coverage of the Market Risk Premium, which dictates the slope of something called the Security Market Line (SML). The SML comes under the asset pricing model known as the Capital Asset Pricing Model (CAPM):
http://www.investopedia.com/terms/m/marketriskpremium.asp
The equity risk premium is actually the risk premium calculated under the CAPM for an individual asset like a stock that is dictated by its individual beta relative to the market risk premium. The market risk premium is what you are asking about which is the risk premium for a market portfolio. And the P/E we are talking about relates to the S&P 500 market proxy.
I don’t think we can explain the largeness of the market P/E. As you can read from the Investopedia link, the total of the risk free treasury bond rate (proxy for the return just for time value of having money tied up) and the market risk premium (return for risk) has been nowhere near 15% over time, a number needed to justify a market P/E of 15. And, of course, 18 adds to the distance; and knowing the 18 is based on non-GAAP inflated earnings again adds to the distance.
Now, understand my take is that the theory of PEG (popularized by Peter Lynch in 1989), namely fair value is where the P/E is equal to the growth rate (expected return), is completely logical, and further, logical even for the overall market; that is not just rational for individual stocks but not for a market index like the S&P 500. But I’m aware that we would rarely see the S&P trading at 1 times the market eps growth rate. But it’s presently well over 3 times; meaning the PEG is over 3. In my view, that IS irrational.
And the market has such a high PEG because many individual stocks have such high PEGs; so, of course the market and individual securities are joined at the hip. I’ll give a few stock names below and their PEGs:
AMZN 8.73
NFLX 2.87
KO over 6
msft 2.61
jnj 3.56
Remember a PEG of 1.0 proxies for a fairly valued security and that means the P/E equals the expected growth rate. If a PEG is 4 on a stock and the P/E is 10, that means expected annual growth is only 2.5% (10/4 = 2.5%).
I can’t really add more. While individual stocks do see their P/E fall below their expected growth rates, the overall market is unlikely to ever trade down to one times its expected growth rate because there are way too many stocks trading at P/Es way above their expected growth rates.
I don’t think anyone is going to be able to offer us a rational reason for the kind of risk premium reflected in the market today.
P.S. I don’t use the PEG in my filter, but if you find a balance sheet standout with a PEG below 1, you probably want to look closer because that might be a buying opportunity if everything else looks on the up and up.
within 4th paragraph of last comment, it says:
“that is not just rational for individual stocks but not for a market index like the S&P 500.”
Better wording:
that is, it’s not rational that the logic behind the PEG only applies to individual stocks but not for a market index like the S&P 500. After all, individual stocks comprise the S&P index.
Thank you so much for that exposition, I always think of these things that puzzle me.
Julian, I do as well and I remain puzzled.