Start looking forward
Earnings season officially kicked off today with Alcoa’s $1.49/share loss versus last year’s $0.75/share profit in the same quarter. The market yawned at the news and share’s moved just 0.5% in aftermarket trading. We all know that earnings this quarter will be dismal. In fact, Thompson Reuters expects negative earnings growth in seven of 10 sectors it tracks.
How could Alcoa investors shrug off such poor earnings? Alcoa’s all important P/E ratio is about to rocket out of control with its shrinking earnings, right? If this trend continues, all the pundits that have been claiming that the S&P 500 P/E ratio is reaching historically low levels must be wrong! The market will become overvalued in just a few days as more earnings falter.
Not so fast. The P/E ratio in basic quotes provided by many financial sites – Google Finance, Bigcharts.com, etc. – is typically based on rolling 52-week earnings. That is, most P/E numbers you see are a trailing metric. Not only that, but these earnings numbers are not “cleaned” for extraordinary or one-time events.
Case Study
Here’s an example of current P/E valuations for a few major credit card companies. I’m using readily attainable data from Yahoo!Finance.
Taking trailing P/E in a vacuum, you might come to the decision that Mastercard (MA) and Visa (V) must be trading at unreasonable premiums. Mastercard is trading at $148/share despite having no earnings. And, you’d be paying a whopping $91 for a beneficial ownership in every $1 of Visa earnings. American Express (AXP) and Discover (DFS) look like much better “values.”
In reality, Visa and Mastercard have been hit by the settlement of two law suits which forced them to make large one-time payments which affected their earnings over the last year. In the future, you’re not likely see them have to make these payments and as a result they ought to very quickly return to higher earnings levels in the future.
If we look at valuations based on estimated next year’s earnings, this is exactly what we see. On a forward basis, the four major credit card processors are, in fact, trading within a very close range. While AXP and DFS still look like the best “values,” it’s now not as clear cut. It can be argued that the premium on MA and V shares is reasonable since they operate solely as payment processors. Discover and American Express, on the other hand, are exposed to consumer credit since they operate as lenders in addition to offering payment processing. Given headwinds around consumer credit , there would seem to be more risk to forward projections on American Express and Discover earnings.
Don’t get me wrong. Forward P/E has its faults. It’s based on consensus estimates from Wall Street analysts and we all learned during the dot-com bubble that their estimates are not always conservative. In fact, if you have the werewithal I suggest constructing run-rate earnings numbers on your own. But, particularly in a recessionary environment, I believe that on-going earnings will be better represented by forward P/Es than trailing P/Es.
Full disclosure: No positions in any of the stocks mentioned.
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