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.
