A better PE ratio

This post is an update to a 4-yr old post titled "Equity valuation exercises." Back then I observed that stocks were fairly valued according to a standard measure of PE ratios (prices divided by 12-mo trailing earnings per share from continuing operations). But they looked to be quite undervalued if measured against the most recent quarterly annualized measure of after-tax, adjusted corporate profits that is produced in the National Income and Product Accounts (NIPA).

Art Laffer long ago taught me the value of using NIPA profits. This measure of profits is based on information supplied to the IRS, and it is then adjusted for capital consumption allowances and inventory valuation. It's been calculated the same way since 1947, and we can be reasonably sure it doesn't artificially inflate profits (who would overstate their profits to the IRS?); Laffer calls it simply "true economic profits." Using this measure, which is calculated quarterly, also gives us a more timely measure of profits, compared to using a 12-mo average of profits.

Here is a chart of PE ratios for the S&P 500 using trailing earnings per share, which suggests that stocks today are moderately overvalued:

And here is a chart of PE ratios for the S&P 500 using NIPA profits (I've normalized the result so that the long-term average is the same as the average for the standard measure of PE ratios), which suggests stocks are only modestly overvalued:

Both methods produce similar results, but the NIPA method suggests that PE ratios are only about 13% above average, whereas the standard method suggests PE ratios are about 28% above average.

For the curious, here is a chart that compares NIPA profits to 12-mo trailing earnings per share (the latest NIPA profits, released last week, are as of Q2/17, while EPS are as of August 2017):

In my 4-yr old post linked above, I discuss some of the reasons for the divergence in these two measures of profits that began around 1990 (e.g., changing accounting standards and changing taxation regimes). Those problems don't affect the NIPA measure of profits, which is why I tend to prefer them.

The two charts above compare NIPA profits to nominal GDP. Note how strong profits have been since the recession of 2001. Since the end of 2001, NIPA profits have almost doubled (+185%), while nominal GDP has increased by only 80%.

Over the years I've argued that this is at least in part due to globalization. Large and successful US corporations have been able to generate a much higher level of profits by selling into the rapidly expanding global market. Global GDP has increased 125% since 2001.

All things here considered, it's not surprising that stocks have done so well of late, and that PE ratios are moderately above their long-term average.