Using Peak Earnings P/E As A Market Valuation Tool

 By: Jamie S Hanson
The price-to-earnings ratio (P/E) is probably the most often used S&P 500 valuation indicator. It is computed by dividing the current price of the S&P (the numerator) by the previous 12 month earnings of stocks in the index (the denominator). The price of the S&P can be found in any market tracking website such as Bloomberg or the Wall Street Journal, and the previous 12 month earnings can be found on the Standard and Poor's website.

The market P/E shifts constantly. That is due to stock prices changing daily and companies reporting new earnings quarterly. The P/E typically expands in a good economy as investors bid up stock prices in anticipation of higher corporate earnings. The reverse is true under poor economic conditions.

Many articles on stock market valuation incorrectly state that a high P/E always means stocks are expensive and a low P/E means stocks are cheap. Using only P/E as a valuation yardstick without an explanation can lead to an erroneous conclusion. P/E does tend to expand in a growing economy as stock prices rise in anticipation of higher earnings, however it can also expend in a recession if earnings fall faster than stock prices. Thus, a high P/E is not always a warning sign of high prices and a low P/E is not always an indication of cheap stock prices.

There are many ways to adjust market P/E to smooth the discrepancy caused by falling earnings during economic downturns. One way is to use future earnings expectations rather than past 12 month actual earnings. However, there are issues with that approach. Stock analysts are often overly optimistic about future earnings growth of the companies they follow, and that makes P/E based on earnings expectation lower than what actually develops. High P/E's in the late 1990s and early 2000s were a good example.

Introducing Peak Earning P/E
An alternative way to look a market valuation that is not often discussed in financial literature is price to "peak" earnings P/E. Peak earnings are the highest reported earnings during an economic cycle. If earnings are going up, past 12 month earnings are used. If earnings are going down, the highest previous 12 month earnings are used from the past cycle.

Some people may question the peak earnings P/E approach because they are concerned about earnings declines in the near future. We would argue that a long-term investor would not focus on near-term earnings expectations. They would long beyond the recession to an economic recovery, and that will generate higher earnings in the future.
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