The Evolution of the Price to Earnings Ratio.
The single most effective way to value a stock, according to Benjamin Graham and David Dodd in the classic 1934 Edition “Security Analysis,” is the P/E ratio of a stock. As with all opportunists, reworking standard analytical procedures can uncover value. Lets take the evolution of the P/E ratio. Their are two main earnings numbers used on Wall Street today when analysts discuss valuations of publicly traded stock: reported earnings and operating earnings.
Graham and Dodd would fall into the reported earnings crowd of “Value Investors,” as a reasonable number to use in calculating a company’s valuation. Today, many call it bearish. A bullish investor would take a rosier outlook and use the operating earnings, which are typically higher and exclude write-offs. Taking operating earnings as your measurement would help to describe the stock market as being less expensive when compared to reported earnings. You ask why should this matter?
Looking at the S & P 500 numbers for 2007 show a significant divergence between operating earnings and reported earnings. In 2007, reported earnings for the S & P 500 were $66, while the operating earnings were $84.54. The estimated numbers for 2008 are $69 for reported earnings and $90 for operating earnings. What makes this a concern is the divergence in the two numbers. Basically, it means there are a lot of write-offs or write-downs.
Many of the consequences of the subprime crisis at financial institutions are referred to as a “write-down”, which is synonymous with a write-off.
While a write-off in banking refers to a bad loan that is declared uncollectable, removing it from its balance sheet, a write-down, according to Investopedia, means: Reducing the book value of an asset because it is overvalued compared to the market value. So while a “write-off” removes the loan from the balance sheet, a “write-down” reduces the value of the loan in the balance sheet. Despite this difference, both terms indicate that the loaned money in question has no chance of being recovered.
A divergence in these two earning’s calculations may play an important part in the stock market for the rest of 2008.
