DAVID BIANCO: The Most Popular Measure Of Stock Market Value Has 3 Major Pitfalls

The most popular and perhaps most trusted measure of stock market value is the Shiller PE, which is also known as the cyclically-adjusted price-earnings ratio.

In short, the Shiller PE is the price of the stock market divided by the average of ten years worth of earnings. If the Shiller PE is above the long-term average, the stock market is considered expensive.

Stock market investors respect the Shiller PE, which is name after Yale economist Robert Shiller, because it accounts for periods of huge volatility and smooths them out.

However, Deutsche Bank's David Bianco thinks that the Shiller PE is still skewed and should be subject to further adjustments.

In his latest note to clients, Bianco makes some adjustments, and finds that the stock market is more attractively valued than initially thought. From his note:

Shiller’s PE has 3 major pitfalls. It doesn’t capture huge shifts in dividend payout ratios; WWI EPS cycle skews history; GAAP EPS depressed by goodwill writedowns in 2000s.

We address the pitfalls in Shiller’s PE by making an equity time value adjustment (EVTA) to historic EPS when calculating 10yr trailing average EPS. Our equity time value adjustment raises EPS from past periods by a nominal cost of equity estimate less the dividend yield for that period. On this basis the valuation of the S&P 500 is still attractive versus the long-term average. We prefer comparing the PE on our 10yr trailing ETVA EPS to the 1960-2011 average to avoid skews from huge earlier period EPS cycles.

Bianco currently expects the S&P 500 to end 2013 at 1,575.

Here's the chart from his note: