Case in point is the treatment of forward operating earnings. The first problem is that analysts tend to treat these as if they are distributable cash flows. Unfortunately, operating earnings exclude a whole range of charges that may not occur on an annual basis, but are legitimate costs and losses incurred as part of the ordinary course of business. Meanwhile, operating earnings often include a benefit from those very same "extraordinary" sources - provided they make positive contributions (witness the large boost to the operating earnings of major banks this quarter, resulting from the reduction in reserves for future loan losses). Forward operating earnings take these hypothetical earnings to the next level, and are based on the year-ahead forecasts of Wall Street analysts.
As long-term readers of these comments know, I am terribly concerned about the increasingly careless use of operating earnings as a measure of stock valuation, because I have yet to see an operating earnings model that is not ignorant, devious, misleading, lacking in historical evidence, repeatedly catastrophic, or all of the above. Not least of these concerns is that the commonly quoted "norm" of 15 for the P/E ratio properly applies to the ratio of the S&P 500 to trailing 12-month net earnings, which are invariably much lower than forward operating earnings. Operating earnings are not even defined under Generally Accepted Accounting Principles (GAAP). They were spawned by Wall Street in the early 1980's, so there is (conveniently) no long-term history for this measure, meaning that the valuation bubble between the late 1990's and 2007 represents a significant chunk of the observable record.
Still, the increasingly common use of this earnings measure requires us to somehow deal with it constructively. As it turns out, the lack of history prior to 1980 is not particularly difficult to overcome. We can very accurately explain the relationship between forward operating earnings and standard earnings measures using variables that have been observable throughout history, and can form good estimates prior to 1980 on that basis (see August 20, 2007 Long Term Evidence on the Fed Model and Forward Operating P/E Ratios ).
It is then straightforward to calculate objects such as the Fed Model (the ratio of the forward operating earnings yield to 10-year Treasury yields), and to demonstrate that it has zero correlation with subsequent market returns.
The question then becomes - is there any way that forward operating earnings (FOE) can be employed as a useful measure of market valuation? The answer is actually yes.
Valuing the S&P 500 using forward operating earnings
I should emphasize from the outset that the proper valuation of a stream of future cash flows requires one to actually model the stream of cash flows earned, delivered as dividends, reinvested, and obtained as terminal, liquidation or buyout payments. Methods that rely on multiples such as P/E, price/revenue, price/dividend and so forth are approximations at best, but perform better if the fundamental being used is relatively smooth, and varying rates of growth are explicitly taken into account.
