Depending on how you’re looking at the S&P 500’s current earnings multiple, there’s a good chance that you could walk away with a pretty divergent view of the how attractive equities are from a valuation standpoint.

If you’re looking at the S&P’s multiple on a trailing basis, you might see that the index is trading at somewhere around 19x earnings, which is a pretty hefty price. On the other hand, if you look on a forward basis, you might find that the index is trading at around 14x earnings, which could reasonably lead you to conclude that stocks are cheap. The difference between the multiples is about 25%, which means that if the forward multiple traded up to the current trailing multiple, the index would be above 2000.

Since the numerator of the P/E’s is the same, the difference is obviously a function of the denominator. In 2012 the S&P 500 earned $90 and in 2013 the published estimates have the $SPX earning $110. Are S&P earnings really going to grow by >20% this year? And if so, where is the growth coming from?

The index level of the S&P 500 is 1658, but that number and the related earnings estimates are really pretty arbitrary, based on an index level set in 1957. The real total market value of the S&P 500’s constituents is $15.75 Trillion. These companies earned $866 Billion last year on a reported basis, which is the number reflected by $90 in index earnings. The current index estimate of $110 implies that the aggregate earnings number would have to get to around $1.03 Trillion next year, suggesting growth of $162 B.

By looking at the bottom up EPS estimates for the S&P 500’s constituents we can get a better sense of where this $162 B is coming from. The majority of the difference is due to the fact that the trailing number represents as reported GAAP earnings, while the $110 number reflects operating earnings before one time charge-offs. For instance, HPQ lost $12 B last year on a GAAP basis (thanks to the autonomy charge-off), although it generated $9 B in EBIT. Based on analyst estimates HPQ’s 2013 earnings will narrow the gap between trailing 2012 and 2013 operating earnings by $19 B . Below is a list of companies that are expected to contribute more than $2 B in incremental earnings to the S&P 500. 60% of the growth is coming from 20 companies and 90% is coming from 50.

From the HPQ example it should be more clear that a lot of the discrepancy between trailing and forward PE ratios may be driven by the fluctuations in GAAP earnings from one time expenses rather than true earnings growth. Perhaps that’s an argument in favor of using the forward estimates as a proxy for more normalized earnings. However, you could make the argument that in the aggregate, one time expenses are actually recurring. In 2012 35 S&P 500 companies lost money on a GAAP basis; in 2013 analysts only expect 7 to lose money on an operating basis.

Source: Avondale Estimates, Compustat Data