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Will the Real Price-to-Earnings Ratios of the Stock Indexes Please Stand Up?

The price-to-earnings ("P/E") ratio remains one of the most widely-accepted valuation metrics in the financial markets today.  However, it is not without its flaws.  For a price-to-earnings ratio to exist, a company must have positive earnings.  Therefore, companies that are losing money have no earnings and a nonsensical "infinite" P/E ratio. 

Major financial firms that produce market indexes, like FTSE, Russell and iShares, exclude these firms when calculating their index price-to-earnings ratios.  However, this could have significant consequences in indexes that have a large number of companies with no earnings, by making the overall index P/E look artificially low. 

Take, for example, the small cap Russell 2000 index.  Almost a third of companies in the small cap index are losing money (i.e., have no earnings).  Global financial firms FTSE and iShares are both reporting the Russell 2000's P/E currently at around 20.  However, as head of global macro strategy at INTL FCStone's Vincent Deluard points out, taking into account the companies that are losing money, the actual P/E of the Russell 2000 is more like 78.7.  This new calculation puts the small cap Russell 2000's P/E far higher than the same measurements at either the top of the internet bubble, or the bull market peak in 2007, as shown below in Deluard's chart.

 

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