By Eric Dutram, DWS

The price-to-earnings (PE) ratio is one of the most fundamental metrics in the world of equity investing. It is a quick and easy way to gauge how much investors are currently paying for a dollar of earnings from any given company.

While the PE ratio represents a snapshot of a company’s relative value from an earnings perspective, it leaves a bit to be desired. That is because just looking at a single year of the earnings picture can be misleading; it does not take into account where in the business cycle the snapshot was taken. For example, if a company is at an extreme end of its cycle, the PE may appear artificially low or high, potentially giving investors a false signal.

Shiller PE

In an attempt to rectify some of these issues, Robert Shiller—a famous finance professor from Yale—developed a ‘Shiller PE’ or a cyclically adjusted PE ratio (CAPE). This ratio takes the current price of a stock or index and divides it by the average of the last 10 years of earnings. The earnings are also adjusted for inflation.

While by no means as popular as the traditional PE, this is arguably a more comprehensive way of assessing the valuation of a stock. Using a 10-year time frame helps to smooth out the effect of the business cycle, while the inflation adjustment mitigates the impact of that factor’s impact on earnings over the long haul.

Limitations

While the Shiller PE is arguably an improvement over the more static ‘regular’ PE, it is by no means perfect. For one, the earnings component of the Shiller PE may arguably be too low. This assertion is mostly the result of changing accounting standards—and corporate actions– which make financial statements based on Generally Acceptable Accounting Principles (GAAP) reflect lower earnings than non-GAAP figures. Why? Because non-GAAP numbers strip out non-recurring or irregular items, helping to smooth out earnings volatility. Stock-based compensation is also treated differently, adding to the divergence between GAAP and non-GAAP earnings.

A better way?

For investors seeking to get past some of the Shiller PE limitations, the “Bianco PE” could be a solution. This metric, which is the brainchild of David Bianco, our Americas CIO, is arguably an improvement when compared to the Shiller method.

The Bianco PE also utilizes a 10-year window and includes inflation-adjusted numbers. That, however, is where the similarities end. The Bianco PE employs non-GAAP numbers to capture a more realistic snapshot of the earnings picture, excluding a variety of one-time charges and write-offs. But the key difference is the treatment of retained earnings.

One would assume that, unless 100% of earnings were paid out as dividends, companies would generate earnings-per-share (EPS) growth above inflation on the profits they have retained. Otherwise, what is the point of holding on to those profits at all? They would be better served in the hands of investors, if for no other reason than to give investors a chance to stay above the inflation level.

In order to account for this, the Bianco PE utilizes the retention ratio and multiplies it by the real cost of equity. This results in an earnings figure that has an equity time-value adjustment, helping to account for the time value of money from earlier periods as well as growth on retained earnings. The thinking is that this may allow for a more accurate look at past earnings, and provide an “apples-to-apples” comparison for EPS across the years.

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