Current estimates of the S&P 500’s P/E are all over the place, ranging from 16 to 134. Which one is right? Depends on your perspective. Bulls almost always use “operating earnings” as the basis for their price/earnings calculations. This method excludes losses/charges seen as “non-recurring” or “one time”. Loan-writedowns, employee stock compensation, and many more items can be labeled as “non-recurring”, and thus excluded from OE.

The result is a subjective and optimistic version of true earnings. It’s kind of like saying, “I made a killing in Vegas this week*. (*excludes losses from blackjack, booze, and strippers)”.

Bears prefer to look at “reported earnings”, or those that adhere to GAAP (Generally Accepted Accounting Practices). We think it presents a more realistic picture of the bottom line. It’s certainly more objective, and has been the traditional way earnings are reported since the 1920s. But in the ’90s, use of Pro-Forma accounting to create operating earnings skyrocketed.

This insightful infographic from The Chart Store speaks volumes on the issue. The bottom-chart shows “reported earnings”, and goes back to 1927. As you can see, the use of “operating earnings” has caused some inflated valuations, to say the least.

Mainstream media outlets typically highlight operating earnings. The problem arises when they say that stocks are “historically cheap”? By what measure? Operating earnings? Companies in the past didn’t exclude losses from their earning statements. So if you use an apples-apples means of measuring, equities are extremely expensive according to historic norms (reported earnings).

Please don’t trade on this data, or anything else I post here. As Keynes said, “The market can stay irrational longer than you can stay solvent”. I’m not a big fan of his, but that one was spot-on. For more info on earnings interpretation, read this Barrons piece from last year. It concluded that reported earnings (the more bearish of the two) is the more fair measure.

Edited and Updated for Clarity on 7/24/09.

No positions in any companies mentioned.