It’s clear to see that one could easily be lead astray by the $2,790 earnings figure, which is the sum of weighted earnings claims. The most significant observation is that the portfolio does not, in fact, hold claim on $2,790 in earnings. This figure exaggerates our legitimate claim of $1,600 by $1,190! Obviously, if one were to calculate a PE ratio on this basis, it would be unrealistically low. Our two-stock example shows that a cumulative dollar, whether earned or lost, is equivalent in the aggregate of a portfolio whether it is derived from a large holding or a small one.
Similarly, index earnings represent the aggregate earnings of all companies in the index, and on this basis the index PE provides valuable information. A high index PE may imply a small, or nonexistent, margin of safety – the central investment concept articulated by Ben Graham, who described it as “the secret of sound investment…” and “always dependent on the price paid…”[1]
For more on the ins and outs of index earnings, see David Blitzer’s post from earlier in the year.
[1] Benjamin Graham, The Intelligent Investor, Revised Ed, pages 512, 517. (New York: HarperCollins, 2003)
This article was written byPhilip Murphy, vice president, North American equities, S&P Dow Jones Indices.
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