10-Year Normalized P/E Ratio (Part 1 of 3)

The 10-Year Normalized Price-to-Earnings ratio, commonly known as P/E 10, was originally introduced by Professor Robert Shiller in his ground-breaking book Irrational Exuberance [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005]. The database used in the book is regularly updated and made publicly available on Professor Shiller’s website (www.econ.yale.edu/~shiller/).

In its simplest version, the ratio is calculated dividing the price of a security (usually a market index such as the S&P 500) by the 10-year average of its trailing-four-quarter earnings per share. The rationale behind this metric is twofold: to obtain a valuation measure that is purely historical (i.e. ignoring any analysts’ estimates of future earnings, which could be biased) and to adjust for the cyclicality in earnings. Figure 1 (below) illustrates how the 10-year average smoothes out earnings volatility, portraying a clearer picture of the long-term trend in earnings.

It is fairly easy to illustrate the power of the P/E 10. For example, using Professor Shiller’s database, we calculated the average five-year annualized S&P 500 return following a P/E 10 lower than 11.16 (the historical 10th percentile) as well as following a P/E greater than 25.38 (the historical 90th percentile). The former is equal to 10.54%, while the latter is equal to 1.13%. Moreover, based on the respective standard deviation and number of observations, the two averages are statistically different from each other with a 99% confidence level. These results constitute strong evidence of the P/E 10’s ability to predict future returns based on valuation.

s&p earnings chart
Sauro Locatelli
About Sauro Locatelli
Sauro joined Pinnacle full-time in January 2011 after completing an internship with the firm over the previous summer. He holds a bachelor’s degree in Business Administration and a master’s degree in Finance from Bocconi University, in Italy. As Pinnacle’s Quantitative Analyst, Sauro is primarily responsible for the management and development of Pinnacle’s in-house quantitative research models, which support the firm’s investment process. In addition, Sauro is an integral part of Pinnacle’s Investment Team, which is responsible for the firm’s asset allocation and security selection decisions. Sauro is a CFA charterholder.