Beware: Russell 2000’s True P/E Ratio Is 78.7, NOT the 20 to 26 Bandied About (+4K Views)

The Russell 2000’s true P/E today is higher than it was at either the top of the internet bubble or the 2007 bull market peak. That’s important information in light of the Russell 2000 dropping below its 200-day moving average. Rather than providing a floor underneath the index, its true valuation will be exerting a force towards even more declines.

This article is an edited ([ ]) and revised (…) synopsis by bmgbullion.com of an article by Mark Hulbert to ensure a faster & easier read. It may be re-posted as long as it includes a hyperlink back to this revised version to avoid copyright infringement.

The Russell 2000’s P/E ratio is 78.7, not the 25.6 claimed by FTSE Russell, the company that created and maintains the index, or  iShares’ popular ETF benchmarked to the Russell 2000 IWM that pegs the index’s P/E at 19.8 as of August 16.

Why the discrepancies in P/E numbers? Well, what neither FTSE Russell nor iShares take into account when calculating the index’s P/E are companies with negative earnings. Since nearly a third of the companies in the Russell 2000 index are losing money, this omission has huge consequences.

Though the proper calculation takes more work, the alternative is the functional equivalent of reporting “profits before expenses.” To calculate an index’s true P/E, you divide the combined total market cap of all component companies by the sum of all those companies’ trailing 12 months earnings.

To put this in context, compare the index’s earnings yield of 1.3% (the inverse of the P/E ratio) to the 2.2% yield on the 10-year Treasury. That means a 10-year Treasury note now yields almost a percentage point per year more than the small-cap sector.

You may have other reasons for believing the small-cap sector to be undervalued right now but don’t try to justify bullishness by claiming that the Russell 2000’s P/E is in the range of 19 to 26.

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