Guys,
When Schweser is describing the formula behind the P/10-year MA (E), they say that both the numerator (price of the S&P500 price index) and the denominator (average of the previous 10 years reported real earnings) are adjusted for inflation.
I can understand the earnings being adjusted, as they refer to past periods. However, WHY and HOW is price adjusted? Aren’t we calculating that ratio for today? So we’d use the current price of the S&P index?
Thanks!
I interpreted P0 as the current price which takes into account inflation to date.
How does the current price takes into account inflation to date?
Maybe I’m thinking about it too simply but If you were to purchase something today, wouldn’t that price account for existing inflation?
Exactly. That’s why you need to strip out inflation of of the current value of the index.
Think of it this way. You always want to compare real values with real values and nominal values with nominal values. If we are adjusting EPS for inflation then we need to adjust P0 for inflation so we can compare two real numbers.
Remove inflation of the index? Can you give an example?
Aren’t we calculating this index for the current period? So inflation would be used on past years earnings, but price would be today’s price?
Did someone understand this?
S & P Index was 100 (base value) when it was set up years ago. Today it is at 20000 (or thereabouts).
What accounts for the difference between the index value year’s ago and today’s value?
Friday it closed at 2,367.34.
Not 20,000. Not even thereabouts. More like somewhereabouts else, emphasis on _ else _.
To answer cpk123.
I can think of a thousand factors, many of which are way more important than inflation. Still, this does not answer my question, but ok.
Piggybacking off of bfry’s point, what value would you get out of comparing a real value (earnings adjusted for inflation) against a nominal value (current S&P 500)? That’s essentially comparing apples and oranges. On the other hand, you don’t HAVE to adjust the current index value for inflation - but you would also have to leave the 10 year earnings unadjusted to come up with a meaningful apples to apples comparison. That is because both the earnings and price incorporate the change in the CPI index over time.
My bad!
I do not trade actively. I hear the news - and got confused between the two numbers they talked about – one in the 20K range the other in the 2K range.
Sorry again!
That makes sense.
But if you are adjusting earnings to the current period, what kind of adjustment would you make to the current S&P value?
That’s the point I’m not understanding.
Considering that you would be looking at the 10 year P/E MA as of current period (for simplicity, let’s just say we are looking at this relative value ratio today), you would have no need to adjust the current S&P value because the index value of today is worth exactly the same value as it is in today’s dollar terms - this is why I was saying that the current price of the index already accounts for inflation.
You are adjusting last 10 year’s worth of earnings because at their face value, they aren’t worth the same as those values in today’s dollar terms.
Apologies if this is making it more confusing but this is how I understand it.
Yes, it now makes more sense. Thats what I meant, if you are looking at the ratio today, there is no need to adjust the numerator.
Thanks!