A version of this post first appeared on TKer.co
Many popular valuation metrics suggest that the stock market is expensive, implying that investors should expect weak returns over the years to come.
Unfortunately, all valuation metrics are far from perfect, and their signals can lead you astray.
Let’s quickly review three popular valuation ratios:
Forward price-to-earnings (P/E): At about 22x, this ratio is above its historical averages. Investors like this metric because it’s based on earnings expected over the next 12 months or next calendar year, and the theoretical value of a stock is closely tied to a company’s future earnings. Unfortunately, most of a company’s value is derived from the earnings generated in the many years beyond the next year. So, the one-year forward P/E lacks scope.
Trailing P/E: At about 28x, this ratio is significantly above its historical averages. It’s calculated using earnings from the past 12 months or the past calendar year. Its strength comes from the fact that these are realized earnings, not guesses. But the obvious disadvantage is that it’s backward-looking, while the stock market is forward-looking.
Cyclically-adjusted P/E (CAPE): At 40x, CAPE is at its highest level since the dot-com bubble. This ratio is a form of trailing P/E, but the E is an average of the past 10 years’ earnings. Popularized by Nobel Prize winner Robert Shiller, CAPE’s strength comes from smoothing out short-term noise, as earnings can be volatile from one year to the next. But again, the major disadvantage is that it’s backward-looking.
Ideally, your valuation model would consider many years’ worth of future earnings (which, by the way, is how discounted cash flow models work.) Obviously, that’s not easy to do. It’s hard enough to predict next quarter’s earnings.
But what if there were a P/E ratio where the E was based on the next 10 years’ earnings? It would be a ratio that combines the strengths of the forward P/E and CAPE.
This sparked a thought exercise on X last week.
While we can’t…
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