Brad DeLong has questioned the conventional approach to calculating P/E10.
Juicy Excerpt: This is not quite right. This gives you permanent earnings five years ago. To get permanent earnings today you have to grow the average by five years of the trend growth rate of real earnings–which has been 6% per year over the past twenty years. The current value of 28 for the price-to-moving-average-of-lagged-earnings ratio corresponds to a price-to-permanent-earnings ratio today of roughly 21, and to a current r of 4.8% per year.
A community member brought this to John Walter Russell’s attention in a recent Letter to the Editor posted to his site.
Juicy Excerpt: He is trying to tie the numbers down to absolutes, to what would be the “right” price to pay for stocks in a theoretical sense. His research is valuable.
John followed up by writing an article entitled Weighted Earnings.
Juicy Excerpt: The 1.06 weight treats all years equally in terms of the long-term trend line. It estimates the Investment Return of the stock market. The 0.94 weight greatly emphasizes recent earnings. It reveals the Speculative Return.
The technical material is over my head. I am pleased to see this sort of discussion going on. I am strongly convinced that using P/E10 is a major advance over using P/E1, the greatly flawed conventional stock-valuation metric. But I do not believe that we are anywhere close to having reached the end of our explorations of the effect of valuations on long-term returns.
We are in the early innings of this ballgame. We need to see many more investing experts and many more ordinary investors making constuctive contributions to the discussions. No small group of people is going to figure all of this out in a definitive way. Projects of this scope and importance require the input of people coming from a variety of backgrounds and perspectives.
The more that I see these sorts of questions discussed, the better I feel about the long-term future of middle-class investing. Rob Arnott has said that we are now in the early stages of a “revolution” in our understanding of what works in stock investing. I think that’s right, and I think that the question of what valuation metrics do the best job is a question that will be brought front and center as that revolution comes to affect the financial furtures of us all in profound ways.
Today’s Passion: Robert Shiller relied on P/E10 to make his famous stock-market prediction of 1996. Did he turn out to have been mostly right or mostly wrong? That question is examined in the article entitled The Famous Robert Shiller Stock-Market Prediction.