How do you determine whether something is cheap or expensive? Often, valuation is expressed in terms of price per unit. For bananas, you calculate the price/pound; for homes, price/square foot; and so forth.
When you own a share of stock, you own a portion of a company. As a result, you own a portion of its earnings. Therefore, stock market valuation is often measured by the price the market is willing to pay for a dollar of yearly earnings -- that is, by the price/earnings (P/E) ratio. To calculate the ratio, you divide the price of a company's stock by that company's earnings (per share) for one year. If the result is, say, 17, your broker might tell you Company X has a P/E of 17, or Company X is selling at 17 times earnings. The P/E is also referred to as the earnings multiple.
Similarly, since you also own a portion of the company's dividends, valuation is sometimes measured by the price/dividend ratio -- i.e., how much the market is willing to pay for each dollar of yearly dividends (per share). Other methods of valuation include price/cash flow and price/book value (the accounting, or "book," value of the company's assets).
Normalized Earnings (NE)
When evaluating the earning power of a business as of some point in time, what earnings should you use? The most recently completed calendar year? The most recent four quarters? The next calendar year? The next four quarters? If you use any of these earnings, you will find that the earnings can vary significantly in a relatively short span of time. The results are much more variable than makes sense to me since they vary more I intuitively think the real long-term earning power of the business is changing. As a result, many investors look for more stable/consistent measures of earnings. Often, they will "normalize" or smooth earnings so that the earnings appear less volatile. I think of this as an attempt to estimate long-term "sustainable" earnings.
In this blog, I normalize earnings by averaging the earnings over an 11-year period -- from 5 years before through 5 years after. (See, for example, the graph of normalized earnings since 1929 in this post.) Other methods for normalizing earnings include using the prior 10 years' earnings (used by Benjamin Graham, Robert Shiller and others), and using peak earnings (used by John Hussman). I often abbreviate normalized earnings as NE.
Normalize Price/Earnings Ratios (NPE)
An important reason for normalizing earnings is so that you can calculate a normalized price/earnings ratio. If you use yearly earnings, the resulting P/E varies more than seems intuitively reasonable. This volatility can be smoothed by using a normalized P/E. I calculate the normalized P/E by dividing price by normalized earnings. I often abbreviate this as NPE. (Note: Some others first normalize the price -- e.g., by taking the average price over a 30 day period.)
Dow Jones NPE
In this blog I treat the DJIA (Dow Jones Industrial Average) as though it were one big company. Therefore, the price I use is the closing price of the Dow Index; earnings (before I normalize them) are the published Dow Index earnings for that year. The Dow normalized P/E ratio (NPE) is, then, the closing price divided by normalized earnings, and is an indication of how cheap or expensive the Dow was at that time -- and, by implication, how cheap or expensive the total stock market was. For an example, see the graphs of normalized P/E ratios in Dow P/E Ratios since 1929.
Note: By definition, my normalized, smoothed, numbers are not available until 5 years after the fact. Thus, they are first and foremost analytical concepts -- tools useful when analyzing history. However, their usefulness is not limited to historical analysis (see, for example, the series on projecting stock market performance).
Last modified 6/6/2011
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