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 decisions. He also serves on Pinnacle’s Investment Committee, which makes the firm’s asset allocation and security selection decisions, with a focus in international markets. He is currently pursuing the professional certification of Chartered Financial Analyst (CFA).
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