I just read an interesting piece by Jeremy Siegel that explains Standard & Poor’s methodology for calculating the earnings for the S&P 500 Index. The S&P 500 Index is a market-weighted index, which means that larger companies (based on market value) are a larger percentage of the index. However, as Dr. Siegel points out in his article, S&P does not account for earnings on a weighted basis:

Unlike their calculation of returns, S&P adds together, dollar for dollar, the large losses of a few firms to the profits of healthy firms without any regard to the market weight of the firm in the S&P 500. If they instead weight each firm’s earnings by its relative market weight, identical to how they calculate returns on the S&P 500, the earnings picture becomes far brighter.

A simple example can illustrate S&P’s error. Suppose on a given day the only price changes in the S&P 500 are that the largest stock, Exxon-Mobil, rose 10% in price and the smallest stock, Jones Apparel Group, fell 10%. Would S&P report that the S&P 500 was unchanged that day? Of course not. Exxon-Mobil has a market weight of over 5% in the S&P 500, while the weight of Jones Apparel is less than .04%, so that the return on Exxon-Mobil is weighted 1,381 times the return on Jones Apparel. In fact, a 10% rise in Exxon-Mobil’s price would boost the S&P 500 by 4.64 index points, while the same fall in Jones Apparel would have no impact since the change is far less than the one-hundredth of one point to which the index is routinely rounded.

Yet when S&P calculates earnings, these market weights are ignored. If, for example, Exxon-Mobil earned $10 billion while Jones Apparel lost $10 billion, S&P would simply add these earnings together to compute the aggregate earnings of its index, ignoring the vast discrepancy in the relative weights on these firms. Although the average investor holds 1,381 times as much stock in Exxon-Mobil as in Jones Apparel, S&P would say that that portfolio has no earnings and hence an “infinite” P/E ratio. These incorrect calculations are producing an extraordinarily low reported level of earnings, high P/E ratios, and the reported fourth-quarter “loss.”

I never thought about this before but Dr. Siegel’s way does seem to make more sense. Maybe they should do both—a market-weighted earnings and P/E ratio and a standard earnings and P/E ratio.

Although stocks seem cheap right now on a P/E basis, they won’t be as cheap if earnings continue to fall. For example:

Say you have a company that is trading at $20 per share and earns $2 per share, giving the stock a P/E of 10. Then lets say this company’s earnings drop 25% to $1.50 per share. If the stock price remains at $20 per share (it most likely wouldn’t if its earning dropped 25% but this is an example), its P/E would now be 13.3 or roughly 33% higher. Remember, the way to think of P/E is the price you pay for each dollar of a company’s earnings. So, with earnings of $2 per share and a $20 stock, you are essentially paying $10 for each dollar of earnings. Now that the earnings are lower, you are paying $13.33 for each dollar of earnings.

There’s no doubt that stocks look a lot cheaper than they have in the past but there are still risks out there. That’s why I think the best thing to do in this market is to dollar-cost average.

Your thoughts on Jeremy Siegel’s thoughts?