Price-to-Fantasy Ratio: Self-Deception with Forward Operating Earnings

A common error of earnings1 aggregation from stocks to the market persists. The aggregation fallacy is at its most extreme during recessions. Consider AIG. During the market lows of 2009, the share price fell briefly below $6 and GAAP (Generally Accepted Accounting Principles) reported earnings were a loss of $90.48. Neither an owner of AIG stock nor an owner of an index fund was on the hook for the $90 loss—their remaining downside risk was not even $6—yet aggregate earnings for the S&P 500 Index were reduced by the entire $90 per-share loss.

We magnify this error if we use forward estimates of earnings rather than trailing earnings, and if we rely on operating earnings rather than reported earnings.

Forecasts of future operating earnings for the market aggregates begin with two sensible assumptions:

  1. Market prices of stocks are based on discounted future earnings, not past reported earnings.
  2. Operating earnings should measure earnings from ongoing operations, excluding nonrecurring extraordinary items and discontinued lines—whether positive or negative—that will not be part of future earnings.

Many analysts will therefore analyze a stock’s price-to-earnings (P/E) ratio, or the P/E for the aggregate market, using forward earnings for the next quarter or next year, which are built on a foundation of recent past operating earnings.

So, what’s wrong with this approach?