Will the Real P/E Ratio Please Stand Up?

Is the U.S. stock market undervalued or overvalued based on its historical Price/Earnings (P/E) ratio? It turns out, the answer could be both! Market analyst Mark Hulbert wrote in a recent column for marketwatch.com that it all depends on how you calculate the measure. Some financial institutions calculate the current P/E ratio of the market based on its last 12-months of earnings (currently richly valued at 24.92), while others base it on the estimated next 12-month earnings (currently a much lower 16.98).

The dramatic difference between the two numbers leads to a world of confusion for individual and professional investors alike. Note that traditionally, the gold-standard for P/E calculations is using the prior 12-months of earnings. Therefore, the next time you hear an argument about whether the market is overvalued or undervalued on the basis of its P/E ratio, make sure that you make the proper distinction between the competing methods.

And, as Hulbert points out, be particularly wary of analysts who misleadingly mix the two by (typically) comparing the forward estimate with the backwards historical value. Hulbert says "Because analysts are almost always too optimistic, projected earnings will be markedly higher than trailing earnings. That in turn means that P/Es based on projected earnings will be significantly lower than P/Es based on trailing earnings. It's an apples-to-oranges comparison."

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