Beware of Historical PEs
The folks at Bespoke Investment Group, writing on Seeking Alpha, offer this tidbit of wisdom:
Before rushing to hit the sell button, however, investors should be aware that the currently stratospheric P/E ratio of the S&P 500 is skewed by the negative quarterly results in Q4 2008 ($-0.09). That number will be replaced by an estimate of $16.73 in Q4 ‘09, which would drop the P/E ratio to a still lofty, although relatively more reasonable level of 20.1 times. What the bulls are really banking on, though, is strong results throughout 2010. Based on current forecasts from S&P, analysts are expecting S&P 500 earnings to rise to $74.98 per share in 2010. With the S&P 500 currently trading at 1,130, the P/E ratio on a forward basis comes all the way down to a much more manageable 15 times. Now all the companies have to do is deliver.
What I’d like to see is a historical ratio that adjusts PEs for leverage. Yes companies have had higher PEs in the last 10 years than they did in the 70s and 80s, but they were probably also more leveraged. Adjusting for leverage is tricky. If you’d pay 10x to buy 100% of a company, how much would you pay to buy 40% of the same company with 60% debt? It makes sense that the multiple should go up, but how much is a function of spread between the company’s borrowing rate and it’s investing rate. And this rapidly becomes a level of analysis way beyond a simple PE ratio.