S&P 500 PE ratio to jump to 30 from 22 for FY 2002 due to S&P now expensing employee stock options in the income statement.
This means that the SPX is still twice the mean PE ratio of the SPX over the past 50 years which is 15-16.
Now clearly the interest rates on the 10 year notes are at the lower end of the range of the past 30 years, so that helps the overvaluation problem a bit. The Market is still too expensive from a Macro perspective.
S&P is additionally going to move the earnings numbers lower by including restructuring charges from ongoing operations. Those costs have currently been ignored in calculating earnings.
S&P is also lowering the positive impact on earnings of gains in corporate pension plans. Which has still been helping some companies this past year due to them using multiyear averages of investment returns to create pension fund gains.
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S&P to Change Its Methodology
For Calculating Operating Profit
By HENNY SENDER
Staff Reporter of THE WALL STREET JOURNAL
May 13th, 2002
NEW RULES ON REPORTS
NEW YORK -- Standard & Poor's is expected Tuesday to announce new standards for calculating companies' so-called operating-earnings results, a move that is expected to focus a spotlight on often opaque earnings reports.
S&P uses operating-earnings data to calculate some of the most widely watched stock-market ratios, including ones tied to the S&P 500-stock index. The firm's move to stricter standards underlines investors' craving for reliable financial snapshots of publicly traded companies in the wake of accounting scandals at collapsed energy trader Enron Corp. The most controversial of S&P's new standards would treat employee stock options as a quarterly expense against earnings. The matter has drawn attention in Congress where Sens. Carl Levin (D., Mich.) and John McCain (R., Ariz.) have proposed legislation that would require companies to show their stock options as an annual expense or risk losing certain tax breaks.
(this post shows the McCain-Levin Proposal)
Message 17075292
(this post outlines how MSFT would have lost 7 billion in 2000, if the Ending of Double standards for Employee Stock options)
Message 17075314
Generally accepted accounting principles, set by the Financial Accounting Standards Board, set standards companies must use for reporting net income. But companies aren't precluded from publicizing other earnings measures
S&P, best known for evaluating companies' credit ratings, has no enforcement power, of course. But its use of the new standards internally, especially when calculating such market bellwethers as the price-to-earnings ratio of companies contained in its S&P 500 index, will make its methodology hard to ignore.
Most immediately, the approach will provide ammunition for those who think the market is too expensive. Using current definitions of operating earnings for 2002, the S&P 500 is trading at a price of about 22 times estimated 2002 earnings. However, using the new definition of core earnings that S&P has just developed, the ratio rises to 30, officials said.
"When you realize the average price/earnings ratio for the last 50 years has been 16 times, you can see that the market is overvalued," said David Blitzer, chief economist for S&P. "The new definition shows that the valuation today is extreme." Besides treating stock options as an expense, S&P will include restructuring charges from continuing operations, even as pension-plan investment gains will be excluded. S&P's new stock-option standard alone will ratchet down its estimated earnings this year for companies in the S&P 500 index by an average of 10%, S&P officials said.
The move by S&P, a unit of McGraw-Hill Cos., represents the latest twist in the growing controversy over "pro forma" profitability measures, which are calculated by many companies across all industries "as if" certain normal business items -- usually expenses -- didn't exist. Companies label these nonstandard profit measures with terms such as "pro forma earnings," "core earnings" or "operating earnings." S&P is responding to investor concerns about such measures, including that wide variation in how such numbers are calculated makes it difficult to compare companies' financial performances. Late last year, S&P said it would seek to create industry standards to eliminate some of the confusion.
S&P's new definition of operating earnings is particularly tough on technology companies, which generally depend on stock-option compensation more heavily than many other companies.
But the exclusion of pension-plan gains, in turn, will be more painful to old-line industrial companies with large pension plans. Moreover, S&P will include annual pension costs even as the investment gains are factored out.
"People will be unhappy about taking out those gains," Mr. Blitzer said. "Everybody has been living off the fat of the bull market." Because of quirks in pension-accounting rules, "even if you lost money last year, you could still show positive numbers by using a three-year average."
Other items S&P favors including in core earnings: write-downs of assets which are depreciable (a write-down is recorded when the fair market value of an asset drops below its net book value) and the cost of buying outside research-and-development services.
Among other items that it says should be excluded from core earnings are goodwill-impairment charges. Goodwill represents the difference between the price paid for an acquisition and the fair market value of its identifiable asset. Other exclusions: unrealized gains and losses from hedging activities and merger-and-acquisition related expenses.
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