Yale's Robert Shiller made headlines by predicting the bursting of the dot.com bubble. More recently, he's been associated with the S&P Case-Shiller Home Price Index. He's also known for valuing stocks with P/E ratios that use trailing-10-year EPS to smooth out bumps in the business cycle. Some refer to this method as "P/E10."

Now he's at odds with Wall Street, saying that stocks are currently pricey by historical measures. His calculations differ from Wall Street's. You may already know Shiller uses P/E10 to value stocks. What you may not know is that he values stocks based on GAAP (Generally Accepted Accounting Principles) earnings instead of "operating" earnings, the earnings before bad stuff that Wall Street favors.

By his calculations, the P/E ratio on the S&P 500 Index is 23x. That's more than 40% higher than its long-term average of 16x. Based on "operating" earnings for the most recent four quarters, Wall Street says the S&P 500 Index is trading at a much more attractive P/E ratio of 14x.

The case for P/E10
It's not just revenue growth that varies with economic cycles. Profit margins do, too. Margins have been rising and are near record levels. In the fourth quarter of 2010 profit margins for S&P 500 Index members were 8.2%, well above the 15-year average of 6.1%.

Profit margins are mean reverting, or in plain English, what goes up must come down. The difference between 8.2% and 6.1% may not sound like much, but reverting to the 15-year average from current levels would reduce profits by a whopping 26% (all else being equal).

Taking a long-term view by using trailing-10-year EPS to value stocks is a good way to smooth out these variances and identify risky prices.

The case for GAAP earnings
How big is the difference between operating and GAAP earnings... the "GAAP gap"? That depends. For quarters since 1988, GAAP EPS has ranged from a low of 25% of operating EPS to a high of 109% with a median of 92%. For 2010 it was a median 92%.

Importantly, the GAAP gap varies tremendously by company and market sector. Last year, the difference was most egregious for the health-care sector, followed by financials and utilities (see table). The GAAP gap gave P/E ratios in those sectors a nasty boost. For example, at the end of 2010 the P/E ratio on the health-care sector was 12.6x based on operating EPS (Wall Street's "before bad stuff" view), but a far less compelling 16.2x based on GAAP EPS.

2010

GAAP EPS % of
Operating EPS

Operating P/E

GAAP P/E

S&P 500

92%

15.0

16.3
S&P 500 Consumer Discretionary Sector

92%

16.2

17.7
S&P 500 Consumer Staples Sector

98%

15.6

15.9
S&P 500 Energy Sector

101%

14.4

14.3
S&P 500 Financials Sector

86%

14.5

16.8
S&P 500 Health-Care Sector

78%

12.6

16.2
S&P 500 Industrials Sector

93%

16.4

17.6
S&P 500 Information Technology Sector

97%

15.4

15.8
S&P 500 Materials Sector

96%

18.0

18.8
S&P 500 Telecommunication Services Sector

105%

17.5

16.7
S&P 500 Utilities Sector

89%

12.9

14.4

Source: Standard & Poor's and the Motley Fool.

Does that mean you should sell your health-care stocks? No. The GAAP gap varies a great deal among companies, even within the same sector. Let's go sector diving and see how it shakes out for the biggest companies in the three sectors with the most egregious GAAP gaps. In the following table, the GAAP gap is "GAAP EPS % of Operating EPS". Lower numbers are worse.

2010

GAAP EPS % of Operating EPS

Operating P/E

GAAP P/E

HEALTH CARE

78%

12.6

16.2
Pfizer (NYSE: PFE)

109%

20.0

18.3
Johnson & Johnson

67%

12.6

18.7
Merck & Co. (NYSE: MRK)

(18%)

124.0

NM

FINANCIAL

86%

14.5

16.8
JPMorgan Chase & Co (NYSE: JPM)

99%

11.3

11.4
Wells Fargo Company (NYSE: WFC)

90%

13.6

15.2
Berkshire Hathaway B

100%

15.3

15.3

UTILITIES

89%

12.9

14.4
Southern Co. (NYSE: SO)

100%

16.0

16.0
Exelon Corp. (NYSE: EXC)

99%

10.4

10.5
Dominion Resources (NYSE: D)

81%

8.8

10.8

Source: Standard & Poor's, CNBC.com and The Motley Fool as of 4/14/11 closing prices.

Pfizer leads this pack when it comes to quality of earnings, with its GAAP EPS actually greater than operating EPS. That can happen from one-time items such as the sale of a business at a profit, but probably isn't sustainable.

Berkshire Hathaway and Southern Company posted respectable quality of earnings as well, with no difference between GAAP and operating EPS. And JPMorgan, widely viewed as the most solid of the big banks, deserves its reputation by this measure.

On the other hand, Merck's results are pretty scary. If it wasn't enough that operating EPS is so depressed the P/E ratio is 124x, GAAP EPS is a loss. And J&J has a pretty embarrassing GAAP gap for such a respected brand name. What looks like a 12.6x P/E is really a much richer 18.7x. Ouch. Dominion Resources is also notable, with what looks like a very low 8.8x P/E ratio actually 10.8x.

Foolish takeaway
Robert Shiller has demonstrated that he is worth listening to. What's more, he doesn't share Wall Street's conflicts of interest. Shiller thinks the stock market is currently pricey based on historical measures. While overvaluations can persist for extended periods, they have always eventually corrected. And corrections typically happen quickly once they are under way.

But not all sectors or stocks are equally pricey. It is a lot of work to value stocks using Shiller's P/E10 method and GAAP earnings. That said, it pays to know where your stocks stand using Shiller's methods in addition to the easily accessible but rosy view that Wall Street dishes out.

Let us know if there is a stock or group of stocks you want to know more about. If there's enough interest, I'll run a valuation based on P/E10 and GAAP.

The Motley Fool recently introduced a free My Watchlist feature. To stay ahead of the curve and receive up-to-date news on the companies of your choosing, add them to your watchlist today: