Be on guard against artificially low P/E ratios that make both mid- and small-cap stocks appear to be more undervalued than they are.
Consider the Russell 2000 Index
perhaps the most widely used benchmark for the performance of the mid- and small-cap sectors. According to data from Birinyi Associates, published in the Wall Street Journal, this index’s trailing P/E was 50.57 as of June 3. That suggests that the sectors this index represents are significantly overvalued. Yet according to iShares, the index’s trailing P/E ratio is 13.45, which would suggest substantial undervaluation.
How can two reputable sources reach such widely divergent conclusions? The answer traces to how they deal with unprofitable companies. The iShares calculation ignores them, while the Wall Street Journal’s data source does not.
This makes a big difference when companies are losing money, which currently is the case for many Russell 2000 constituents. No fewer than 43% of its constituent companies lost money over their most recently reported 12-month periods, according to my calculations based on FactSet data.
I should stress that iShares does not hide that its calculations ignore unprofitable companies. It plainly states on its website for the iShares Russell 2000 ETF
that “negative P/E ratios are excluded” when calculating the ETF’s average P/E.
Nevertheless, a more complete picture of the index’s valuation requires taking these unprofitable companies into account. To be sure, such an accounting involves a few additional steps. One needs to add up the total EPS of each component company, whether profitable or unprofitable, weighting it according to the stock’s weight in the overall index. That total then becomes the denominator of the index’s P/E ratio.
The failure to include unprofitable companies doesn’t make such a big difference when almost all of the companies in an index are profitable. That’s the case currently with the large-cap S&P 500 index
for example: Just 4.4% of its constituent companies lost money in their most recently-reported 12 month periods.
Moreover, most of these unprofitable companies have relatively smaller market-caps and therefore represent a tiny portion of the overall index. I calculate that the failure to take these unprofitable companies into account causes the S&P 500’s P/E ratio to be just 3.3% lower than it would be otherwise. That is a lot less significant than in the case of the Russell 2000.
The bottom line: We get a false picture of the mid- and small-cap sectors by ignoring the nearly half of Russell 2000 stocks that lost money over the past 12 months. While it’s still possible that these sectors will produce handsome returns in coming months, bullish investors will need to support that possibility on something other than the Russell 2000’s trailing 12-month P/E ratio.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]