(Y)earning for the Truth

The measurement of price per earning can vary depending on what earnings basis is used to perform the calculation. Year on year this variability can ‘muddy the waters’ as to whether the market represents value or not.

Over the longer term the various PE calculation methods tend to huddle around the same numbers. It’s the trend that is useful in guiding the decisions of long term, patient investors.

Even if all methods agreed on the actual level of earnings, it does not mean the PE is an accurate reflection of value.

Ever heard the term ‘creative accounting’? What if reported earnings do not reflect underlying revenue? Anyone remember Enron?

The doyen of value investing, Benjamin Graham (Warren Buffett’s mentor) preferred to use the earnings average of the previous ten years for his calculations. The ‘smoothing’ of earnings helped reduce the distortion of creative accounting.

The current PE (by any measurement) is above average. What if that higher than average multiple is being applied to exaggerated earnings?
Then we have a market in seriously overvalued territory.

Earnings Per Share (EPS) Are Falling

The following chart, courtesy of Full Circle Asset Management, shows S&P 500 EPS has been flat lining since 2nd Quarter of 2011. In spite of this, the market has continued to pay a higher price for these earnings.

Is this because Wall Street, awash with Bernanke’s largesse, has nothing better to do with the money? All aboard the one-way trade.

It is timely to remind ourselves of what the true function of the share market is.

‘In the short run, the market’s a voting machine and sometimes people vote very non-intelligently. In the long run, it’s a weighing machine and the weight of business and how it does is what affects values over time.’

– Warren Buffett


Ultimately a company’s earnings determine its value. Remember the ‘tech boom’ and the promises of all those start up dotcoms? In the short term (late 1990’s) the market voted non-intelligently, but in the long term it weighed up the merits of these offerings and the vast majority have been consigned to the dustbin.

Earnings matter — they are the E in the P/E ratio.

Thanks to the good people at Full Circle Asset Management, the following chart shows US corporate earnings minus extraordinary items (one-off gains from asset sales etc).

Strip out these items from the profit reports and underlying earnings (the recurring revenue that values a company) are actually falling.


In fourth quarter 2012 the underlying EPS was back to the levels of fourth quarter 2006. Real earnings have stagnated for six years.

In spite of this data, Wall Street analysts are still forecasting EPS growth over the coming 12 months (those good folk should apply for a position with the Australian Treasury).

Share Buybacks Distort the Data

The Financial Times in March 2013 reported US share buybacks since March 2009 have exceeded $1 trillion dollars. According to recent data, in February 2013 share buybacks totaled $118 billion. Annualised this equates to a possible $1.4 trillion of buybacks this year.

What is the relevance of the share buy back? When a company uses its cash or borrowed funds to buy-back its shares, the shares are then cancelled. Fewer shares increases the EPS figure.

For example, let’s say Company A has issued 1 million shares and produces earnings of $1 million. EPS is $1. If Company A buys back half the issued shares, the EPS would double to $2. ($1 million divided by 500,000 shares).

The following chart from www.multpl.com shows quarterly earnings minus the impact of the buybacks.


The combination of falls in ‘genuine’ earnings together with EPS being inflated by share buybacks, paints a different picture to the one the investment industry promotes.

The following chart from Federal Reserve Economic Data (FRED) shows US Corporate Profits (after tax) as a % of GDP are the highest they have ever been.

This is the weakest US economic recovery from a recession since The Great Depression — yet corporate profits are rising!

Does something not smell right to you? Earnings boosted by asset sales, cost cutting, share buybacks etc are not real earnings.

Watch Out Below

So what happens when the Secular Bear springs its trap — a shrinking PE combined with a reduction in earnings? Carnage.

Let’s do the math. PE falls from 20x to 5x and earnings fall (mean revert) 50%.

Company earning $1.0M x 20 = $20M
Company earning $0.5M x 5 = $2.5M

A massive 87.5% reduction in value.

Impossible. Not going to happen. There will be anarchy. These are the usual responses to this equation.

So what do we know that we have chosen to forget?

We know credit bubbles always burst — The Great Depression and Japan post-1990.

We know credit contractions create extreme pain and hardship. This pessimism is ultimately reflected in low PEs.

We know at the darkest hour of previous Secular Bear Markets, PEs have fallen into the 5x range.

We know US corporate earnings are at historically high levels.

We know what goes up must come down — mean reversion.

We know simple math doesn’t lie.

We know gravity trumps levitation.

What we don’t know is how to cope in a world without artificially induced growth. The forces of economic nature have a lesson in store for us.

Next week we look at how to build a bunker to withstand the ferocity of the Secular Bear.


Vern Gowdie
for Markets and Money


Join Markets and Money on Google+

From the Archives…

Multinationals vs. the Nation State
17-05-13 – Sam Volkering

The Federal Reserve Will Panic and Climb Even Higher
16-05-13 – Bill Bonner

Survival of the Most Capital Efficient
15-05-13 ­– Dan Denning

New Australian Home Buyers Aren’t Convinced
14-05-13 – Dan Denning

What Happens When Everyone in the World has Zero Interest Rates?
13-05-13 – Dan Denning

Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

To read more insights by Vern check out the articles below.

Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money