By an interesting coincidence, this week’s Thoughts from the Frontline by John Mauldin addresses a problem that not only economists but also investors have, how to interpret the numbers that our economic models spit out, numbers like the P/E ratio.
Weapons of Economic Misdirection
The problem we have today in economics is that many people, and not a few economists, seem to regard economics as “pure science,” as described above by Gauri Shankar Shrestha. If you delve deep into measurement theory, you find that all too often the way in which you measure something determines the results obtained from your experimental model. How you measure the effectiveness of a drug can sometimes determine whether it gets approved – apart from whether it actually does any good. The FDA actually works rather hard at measurement theory.
And if you’re using models, as we do in economics, to determine policies that govern nations, your efforts can result in economic misdirection that seems for a time to work but that all too often can lead to a disastrous Endgame. A shortsighted economic policy is not unlike a drug that makes one feel good for a period of time but ultimately leads to further weakness or collapse.
In this week’s letter we look at the construction of gross domestic product (GDP). As we will see, GDP is a relatively late-to-the-party statistic, thoroughly malleable in its construction and often quite contentious in its application. Yet the mainstream media regularly releases GDP numbers with the implicit assumption that they are in fact an accurate reflection of the general economy. We shall soon see that GDP is instead a fuzzy reflection of the economy, derived from a model that is continually readjusted in a well-intentioned effort to understand the scope of the economy.
With a changing GAAP to accommodate many competing interests* it should not come as a surprise that certain numbers thrown off by this particular model change overtime. At Saul’s board one of the alternative metrics (to fix GAAP) is adjusted or non-GAAP earnings. If you don’t trust GAAP earnings you can’t trust GAAP derivatives like GAAP P/E either.
We fixate on numbers because they make rules of thumb easy to use (useful when confronted by a hungry tiger and no time to ponder) but they also can distort reality. People fixate on the P/E ratio of indexes which are already a composition of disparate businesses like waste management and rocket launchers. P/E is the inverse of yield. Clearly not all assets have the same yield therefore a single P/E number is not adequate for all assets. I would love to buy AMZN at the P/E ratio of car assemblers!
The question stands, “Sell what?”
- Double entry accounting was invented in Italy to help the Italian merchant houses keep track of their far ranging interests. It was not designed to help out governments. One of the earliest “competing interests” was created by the introduction of income tax. What better tool did the government have than the corporate P&L statement to determine the tax. The conflict of interest is clear, the company wants to pay less and the government wants to take more. The accounting system is now under undue stress! Two recent stresses are the expensing of stock options and the mark-to-market of certain liabilities like warrants and stock options. GAAP as a management tool is close to useless below the gross profit line.
“Adjusted” numbers are not exempt from competing interests, management wants to make itself look good.
Who or what then to trust? In my view, Mr. Market is the ultimate payor and arbiter of value!
What is ‘Earnings Yield’
Earnings yield are the earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock that was earned by the company. The earnings yield is used by many investment managers to determine optimal asset allocations.