Investing to Wealth

In Wednesday’s Wall Street Journal, Wharton Business School Professor Jeremy Siegel pointed out a the quirky nature by which Standard & Poors calculates earnings for the S&P 500 index.  Needless to say, in this painful global economic slowdown, corporate earnings have fallen dramatically.  However, S&P’s recent announcement forecasting that the S&P 500’s fourth quarter earnings would be negative for the first time since this data was first calculated in 1936, cast a pall over an already despondent market.  Further the projection of earnings of only $40 a share for the S&P 500 for all of 2008 makes the stock market’s P/E Ratio look far more pricey than one would expect at this point in a brutal bear market.

However, much of this glum news is based solely on a quirk in the way S&P calculates aggregate earnings for its indices.  Quoting from Professor Siegel’s column:

What this dismal news actually reflects is the bizarre way in which S&P (and most other index providers) calculate “aggregate” earnings and P/E ratios for their indexes. Unlike their calculation of returns, S&P adds together, dollar for dollar, the large losses of a few firms to the profits of healthy firms without any regard to the market weight of the firm in the S&P 500. If they instead weight each firm’s earnings by its relative market weight, identical to how they calculate returns on the S&P 500, the earnings picture becomes far brighter.

As the fourth-quarter earnings season draws to a close, there are an estimated 80 companies in the S&P 500 with 2008 losses totaling about $240 billion. Under S&P’s methodology, these firms are subtracting more than $27 per share from index earnings although they represent only 6.4% of weight in the index. S&P’s unweighted methodology produces a dismal estimate of $39.73 for aggregate earnings last year.

If one applies market weights to each firm’s earnings using the same procedure that S&P employs to compute returns, the results yield a more accurate view of the current profit picture. Market weights produce a reported earnings estimate of $71.10 for 2008 — nearly 80% higher than the unweighted procedure. The reason for this stark difference is that the firms with huge losses generally have extremely low market values and hence have a much smaller impact on the total earnings in the index.

Similarly, operating earnings (essentially, earnings before write-offs), of the S&P 500 are boosted to $81.94 per share when earnings are weighted by market value, yielding a P/E ratio of about 9.4 for the market, instead of S&P’s $61.80, which yields a P/E ratio of 12.5 when firm profits are simply added. Even the negative earnings for the fourth quarter disappear when market weights are accounted for, as fourth-quarter GAAP earnings on the S&P 500 Index total $7.44 per share and operating earnings reach $14.40.

Thus, as you can see, when factoring in cap weighting to the earnings calculations, the current earnings multiple for the S&P 500 is much closer to the price-to-peak earnings ratio and is much more in line with the type of very low P/E ratio that normally accompanies the end stages of a protracted bear market.

Jeremy Siegel Says Stocks Are Cheaper Than They Look