Overvalued operating profits increase risk for the S&P 500 even after the index falls in 2022

Operating result calculated by S&P Global (SPGI) for the S&P 500 overstates core earnings,[1] throughout 2021.

Stocks are more expensive than they appear based on operating earnings. Despite falling around 6% in 2022, the current valuation of the S&P 500 requires earnings growth above what analysts are expecting, increasing downside risk for the index.

S&P Global’s fall and rebound in earnings are overstated

Over the past two years, earnings for S&P 500 companies haven’t fallen as much, and the rebound hasn’t been as robust as investors suggest. For 2021 versus 2020:

  • SPGI’s operating profit increased from $122.37/share to $208.07/share, or 70%
  • Basic earnings fell from $123.17/share to $197.29/share, only 60%
  • SPGI’s operating income was 1% lower than base income in 2020 and 5% higher in 2021.

The reason for these differences is that SPGI’s operating results contain unusual expenses that cause an exaggerated decline in 2020 and unusual revenues that cause an exaggerated rebound in 2021. See Figure 1.

Figure 1: Trailing Twelve Month Earnings: SPGI Core Earnings vs. Operating Earnings: 4Q19-4Q21[2]

Sources: S&P Global (SPGI). Note: SPGI’s most recent period operating income data is based on consensus estimates for companies with non-standard fiscal years.

More details on the calculation of base incomes are available in Annex I.

The S&P 500 is more expensive than operating income implies

At the end of 2021, S&P 500 core earnings hit new highs, surpassing previous records set during the TTM that ended in 2Q21 and 3Q21. The bear market that began in 2022 has closed the gap between the valuation of the S&P 500 and its true fundamentals, but not as much as many investors think.

As operating earnings continue to overstate S&P 500 core earnings, the index requires continued growth in investor optimism about future earnings to support its valuation. We have already seen many companies report slowing growth, which has helped drive the market into “correction” territory on several occasions this year. As long as investors perceive profits to be higher than they actually are, they are taking on more downside risk than they realize.

Figure 2 shows that the S&P 500 P/E ratios based on SPGI’s core earnings and operating earnings have fallen significantly from their March 2021 highs. Valuations peaked in 2021, but SPGI’s faster rebound in operating profit translates into a lower P/E ratio based on operating profit than when using core profit. The S&P 500 looks like cheap when measured using operating profit, but not when the more precise measure of core profit is used.

Figure 2: Price-to-Core vs. Price-to-SPGI Operating profit: TTM at 31/12/15 – 11/03/22

The Core Earnings P/E ratio aggregates TTM results for constituents through 6/30/13 and aggregates four quarters of results for S&P 500 constituents in each measurement period thereafter. SPGI’s P/E is based on four quarters of aggregate S&P 500 results for each period. More details in appendix II.

Basic income is a less volatile and more reliable measure of income

Figure 3 highlights the percentage changes in SPGI’s core earnings and operating earnings from 2004 to present (through 11/3/22). The difference in metrics is due to flaws in older datasets that prevent capturing unusual gains/losses buried in footnotes.

Figure 3: Basic operating earnings per share vs. SPGI for the S&P 500 – % change: 2004 – 3/11/22

Basic earnings analysis is based on aggregated TTM data through 6/30/13, and aggregated quarterly data thereafter for S&P 500 constituents during each measurement period.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, style, or theme.

Appendix I: Basic Income Methodology

In the figures above, I’m using the following to calculate base earnings:

  • aggregated annual data for S&P 500 constituents for each measurement period through 6/30/13
  • aggregated quarterly data for S&P 500 constituents for each measurement period from 6/30/13 to present

Although I prefer aggregated quarterly numbers, I looked at the potential impacts of the two methodologies and found no significant differences.

Appendix II: P/E Ratio Methodology for Core & SPGI Operating Income

In Figure 3 above, I calculate the base P/E ratio through 6/30/13 as follows:

  1. Calculate a TTM earnings yield for each component of the S&P 500
  2. Weight earnings returns by each stock’s respective weight in the S&P 500
  3. Add the weighted earnings yields and take the inverse (1/earnings yield)

I calculate the Price/Core Earnings ratio for periods after 06/30/13 as follows:

  1. Calculate a trailing four-quarter earnings yield for each component of the S&P 500
  2. Weight earnings yield by each stock’s respective weighting in the S&P 500
  3. Add the weighted earnings yields and take the inverse (1/earnings yield)

I use the earnings yield methodology because P/E ratios do not follow a linear trend. An AP/E ratio of 1 is “better” than a P/E ratio of 30, but a P/E ratio of 30 is “better” than a P/E ratio of -15. In other words, aggregating P/E ratios may result in a low multiple due to the inclusion of only a few stocks with negative P/Es.

Using earnings yields solves this problem because a high earnings yield is always “better” than a low earnings yield. There is no conceptual difference when moving from positive to negative returns as there is with traditional P/E ratios.

By using quarterly data as it becomes available, I better understand the impact of changes on the constituents of the S&P 500 on a quarterly basis. For example, a company could be a constituent in 2Q18, but not in 3Q18. This method captures the ever-changing nature of the S&P 500 riding.

For all periods in Figure 3, I calculate SPGI’s price to operating earnings ratio by adding the previous 4 quarters of operating earnings per share, then dividing by the price of the S&P 500 at the end of each period of measurement.

[1] Core earnings research is based on the latest audited financial data, which is the 2021 10-K calendar in most cases. S&P Global’s operating profit is based on the same period.

[2] 4Q21 refers to 2021 Calendar 10-K financial data and price data as of 3/11/22 (earliest date all 2021 Calendar 10-Ks for S&P 500 constituents were available).

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