Articles for Financial Advisors

Understanding P/Es

Understanding P/Es

A company’s P/E ratio is its stock price divided by a year’s worth of its per-share earnings. It is one measure of how much investors are paying for the value a company creates. The S&P 500’s P/E is useful for sizing up the broad market at a glance. 

 
As of January 2012, the S&P 500 was trading at 14.5 times trailing earnings (actual earnings over the previous four quarters). Between 1872 and 2000, U.S. stocks had an average P/E of 14.5 (source: Federal Reserve Bank of Kansas City).
 
Yale economist Robert Shiller advocates using 10 years of earnings, adjusted for inflation. His “cyclically adjusted P/E” is 20.8, versus an average of 16.4 since 1881.
 

Operating Earnings

A variation of the P/E ratio is to use “operating” earnings, as defined by regulators. According to S&P, there is no legal definition for operating earnings; it is more principle. A good way to look at operating earnings is if a company wanted to know what it made from the sale of its products, not how much the company paid to finance production. Based on operating earnings, the S&P has a P/E of 13.4, versus an average of 19.1 since 1988. Unfortunately, the historical data on operating earnings is not extensive enough to make this indicator reliable.
 

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