US stock valuations based on forecast operating earnings regularly veer into ‘fantasy’ land, according to a new analysis by quantitative investment firm, Research Affiliates (RAFI), with reality set to disappoint again in 2023 as recessionary risks remain.
The study found share analysts have consistently over-valued the S&P500 in aggregate when using forecast operating earnings rather than backward-looking reported income.
But the valuation approach rests on two flawed assumptions, namely: share market prices are based on discounted forward earnings not past reported earnings; and, that operating earnings accurately reflect company income.
Both assumptions, though, introduce a “large bias into aggregate market earnings” estimates, which invariably land on the upside.
“Over the last 34 years, data provided by S&P show that aggregate S&P 500 reported earnings have been an average 5% lower than prior-year operating earnings, despite powerful growth in both reported and operating earnings over the same span,” the RAFI paper says. “The same-year comparison is even larger: concurrent reported earnings are lower than operating earnings by 13%.”
And the mis-match between forecast operating earnings and reality widens further during recessionary periods, RAFI found.
“In 2001 and 2002, in the same period aggregate operating earnings exceeded reported earnings by 57% and 70%, respectively,” the study says. “In 2008, aggregate operating earnings exceeded reported earnings by 233%. In 2020, aggregate operating earnings exceeded reported earnings by 30%.”
However, current consensus forecast aggregate earnings for the S&P500 of US$226 over 2023 (implying a P/E ratio of 17) would require a massive 25 per cent year-on-year earnings growth, the RAFI paper says,
“If reported earnings next year merely match the likely final 2022 level of $181, then the current price-to-forward earnings (P/F) ratio is 21,” the analysis says. “In 2023, if earnings tumble just 20% from 2022 levels, then the correct current P/F ratio is 26, hardly a bargain. It is easy to see why we occasionally refer to the P/F ratio as the Price/Fantasy ratio.”
Published this month, the ‘Price-to-fantasy ratio: self-deception with forward operating earnings’ was penned by RAFI founder, Rob Arnott, and chief executive, Chris Brightman.