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Valuing the market by P/E ratio

You’re probably familiar with the price to earnings (P/E) ratio as applied to individual shares.

Well, the same sort of metric can be used – subject to the usual laundry list of caveats – to try to decide if an entire market is cheap.

A quick refresher. To calculate a company’s P/E ratio, you simply divide its share price by its earnings per share.

Monevator PLC has a share price of £10 and earnings per share of 50p.

The P/E ratio is £10/50p = 20

As a quick and dirty rule, a high P/E ratio indicates there’s a lot of future growth expectations baked into the share price, while a low P/E may indicate the market doesn’t expect so much growth from the company in the future.

Such expectations about earnings can involve all kinds of things, from a new product launch or a shift in the perception of margins, to some big crisis like the BP oil well disaster that takes a scythe to anticipated profits. They all work back into the P/E ratio.

It’s no exact science, but by comparing a company’s P/E ratio to that of its rivals and to its own historical range, you can try to get a feel for what other investors are expecting.

And the same sort of thing can be done for markets.

To calculate the P/E ratio for a stock market or index, you divide the total market value of all of the market’s constituents by their combined earnings.

Or, rather, you have someone else do it for you!

The Bloomberg terminals used by professional City folk deliver P/E ratios for different markets at a stroke.

Commoners must trawl around more or less accessible resources. The Financial Times data section enables you to download various index and country level P/Es, for instance.

You will also find journalists, analysts, and yours truly peppering articles with index or country P/E ratios.

Learning about earnings

It’s important to establish exactly what P/E ratio is being used.

The ‘P’ part of the equation for a simple P/E ratio is always the current price.

But with companies, different earnings (the ‘E’ figure) can be plugged in to give you an insight into slightly different views about the company.

  • Using historic earnings tells you how highly the company is rated on the basis of its last full financial year’s earnings. (Note: In the US where companies report quarterly, the trailing four quarters is most often used).
  • Forecast earnings plugged into a P/E ratio gives an indication of how cheaply – or expensively – the market is rating next year’s earnings.
  • A third variant gives you a mix of both, by adding the last reported half-year’s earnings with the earnings expected in the next two quarters .

And the same variations be used when calculating the P/E for the market.

Which P/E ratio is best? It doesn’t really work like that.

Comparing historic P/Es from different years can tell you how optimistic or pessimistic the market has been in the past – or how much it’s been surprised – but it doesn’t tell you much about the price you’re paying today.

Forecast earnings are the most important to the future value of your investment, whether you’re looking at a company or an index.

Unfortunately forecast earnings are also the most unreliable, because they haven’t happened yet! (Perfect your crystal ball and you’ll be rich in no time).

It’s therefore a good idea to look at all the different P/E ratios to get the most rounded picture you can.

If a company or market is rated at a P/E of 20 on a historical basis but only 5 on a forward basis, say, you need to understand what happened in the past or what’s expected in the future to make earnings swing about so wildly.

Uses and abuses of the P/E ratio

Let’s get back to valuing the market by P/E ratio.

By comparing its P/E with its historical range, with other markets, or with the P/E at other points in time – say in the depths of a previous recession – you can hazard an opinion as to whether it now seems to be pricing in too much optimism or pessimism, given your view of the economic situation.

Beware that such comparisons involve plenty of uncertainty and ambiguity – on top of the sheer unreliability of the macro-economic forecasting that will surely influence your view of a market’s future earnings.

Comparing the P/Es of two different markets can be misleading, for instance, because the P/E tells you nothing about the balance sheets of their respective companies.

One market’s firms may typically be more conservative and so use less debt, while another’s may be geared to the eyeballs. That’s likely to change the attractiveness of those future earnings to different investors. The cash-backed companies are on average probably safer, and so may deserve a premium rating. Or alternatively you may feel they’re too conservative, and so unlikely to grow.

Different markets are also biased towards different industries. An index dominated by resource companies will probably be more at the mercy of the economic cycle than a more diversified index, so I’d expect it to generally trade on a lower forward P/E multiple than a market stuffed with consumer staples.

There are even issues with comparing the same market across time.

You might compare an index’s P/E in what seems you like the trough of a bear market with an even lower one from a similar crash in the 1970s, only to decide it suggests that the current market has a lot further to fall.

But what those figures don’t reveal is that general interest rates were say 10% in the prior bear market whereas they might be (for example) only 2% when you make that comparison.

So you’re not really comparing similar investment environments.

Markets, moods, and P/E ratios are all cyclical

Because earnings fluctuate as economies expand and contract – and because investor enthusiasm is cyclical, too – investors may seek to smooth out a P/E ratio over a number of years.

I’ll look at this so-called cyclically adjusted P/E ratio (most commonly termed PE 10) in the next part of this series.

To conclude this post, valuing the market by its P/E ratio is a useful shortcut to getting a sense about how other investors see that market.

But it is definitely not a foolproof guide to future returns for all the reasons stated – and also because there’s “nowt so daft as folk”!

A market may seem cheap to you by its P/E ratio and yet get cheaper for years or vice-versa, purely because your fellow investors become more fearful or greedy.

Such sentiment will resolve itself eventually in all but the most apocalyptic scenarios. There’s a common sense limit to just how low a P/E multiple can get for an entire market, in most circumstances.

As always with equities though, you’d better be ready to strap in for the long-term.

Series NavigationValuing the market: Are shares cheap?The cyclically-adjusted P/E ratio (PE10 or Shiller PE)

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{ 11 comments… add one }
  • 1 UK Value Investor April 27, 2012, 12:41 pm

    Hi M. I’ve always preferred PE10, for companies but especially for markets as it’s a much more stable indicator of value. Getting the data can be a pain but it’s then possible to make reasonable guesses at the markets value. The historic average PE10 in the UK is between 12.5 and 15 from the data I have seen.

  • 2 Ca$hMoney April 27, 2012, 2:51 pm

    Good discussion, Investor. Looking back at historical P/Es, it’s also important to consider the inflationary and interest rate environments at those points in time relative to today. Same goes for comparing global markets. High inflation and interest rates generally suggests low P/E, and vice versa.

    To make the P/E ratio more intuitive, I like to invert it into “earnings yield”, or E/P, where a 15 P/E implies a 6.67% earnings yield. That way, when you compare it to prevailing interest and inflation rates, it makes more sense. If I can buy a 10-year gilt yielding 8%, it makes sense that the market P/E should decline below 12.5x (1/8%) to attract investor funds.

    Have a great weekend!

  • 3 The Investor April 27, 2012, 6:02 pm

    @Ca$hMoney — Thanks for your thoughts and good one raising the earnings yield. I’m also going to cover this a bit later in the series when I get to the Gilt/Equity Yield ratio.

    That said, we certainly live in distorted times when it comes to gilts, IMHO, so valuing by the earnings yield could be a bit misleading.

    You can currently buy a 10-year gilt yielding around 2%, which means the FTSE 100 P/E could stand to be 23 on a forward basis, by your rule of thumb. That would elevate the FTSE by about 130%, to around 13,000.

    And people keep telling me the stock market looks expensive. Compared to what? 😉

  • 4 UK Value Investor April 27, 2012, 7:58 pm

    “And people keep telling me the stock market looks expensive. Compared to what?”

    The only thing I’ve seen so far that is a useful comparison for current stock market levels is past stock market levels. Comparing to bonds is difficult. There have been various studies but from what I remember there weren’t any reliably usable conclusions.

    Comparing the stock market to its past self does seem to allow you to say something sensible about the expensiveness of the market. See the ‘valuing Wall St’ books by Smithers and the CAPE work of Shiller.

  • 5 Fiscalist April 27, 2012, 8:58 pm

    Or is the 10 year gilt wildly overvalued whilst stocks are fair or even overvalued? If so, should one be shorting gilts and how would one do that?

  • 6 The Investor April 27, 2012, 9:04 pm

    @UKVI — Yep, agreed. If bonds were a hit-and-miss comparator for valuation in the past, they can’t be much use in these strangely distorted times. (Except perhaps in as much as central banks are urging us along the yield curve, by making risk-free near return-free… 😉 ).

    As I say, PE 10 / Shiller etc coming next week.

  • 7 The Investor April 27, 2012, 9:10 pm

    @Fiscalist — Could be, yes. The most practical way to bet against gilts / fixed interest for private investors I think is simply not to hold any, given that most asset allocation models would include a big slug of them and you’re taking a big risk eschewing the class entirely (though in some respect cash isn’t a terrible substitute for private investors, albeit certainly not a direct swap).

    That’s the situation I’m in currently (and it wasn’t particularly profitable in 2011).

  • 8 The Accumulator April 30, 2012, 9:32 pm

    The best resource I’ve found for P/E is Morningstar. Set up a dummy portfolio, pop in any fund you like, go to the Fundamental tab and you’ll get a forward P/E ratio for that fund. If it’s a tracker then effectively you’ve got a forward P/E reading for its market.

  • 9 Shares Coach May 1, 2012, 9:29 am

    Great article about P/E ratios and market-level P/E’s in particular. I’ve written similar articles recently and also about the PEG ratio, which you don’t mention.

    Essentially, though, you provide a great argument for buying companies instead of markets. Whilst you still have many of the issues you describe at the company level, they are easier to analyse and understand than they are at market level.

    Not only that, but why would anyone want to buy shares in poor performing companies which is what you are doping if you are buying a market tracker, ETF, or similar.

  • 10 The Investor May 1, 2012, 10:52 am

    @Shares Coach — Thanks for the positive comments you’ve left around the site.

    You write: Not only that, but why would anyone want to buy shares in poor performing companies which is what you are doing if you are buying a market tracker, ETF, or similar.

    The answer is simply that most people, including the majority of active fund managers, fail to beat the strategy of passively following the market. So while your logic is right – who wants to buy a poorly performing company? – in practice people can’t tell them apart.

    I don’t buy active funds at all except for investment trusts (usually on a discount) because the charges are so hard to overcome on top of the challenge of beating the market, even though I admire the thinking of some active fund managers.

    I do trade a big slug of my money actively myself, but I don’t do so because I *expect* to beat the market. I do so because I might, and because I enjoy trying.

    If anything, I except to fail on a medium term view. But not by much, and for me the risk/rewards in tandem with the intellectual challenge of stock picking are attractive.

  • 11 Always a question October 17, 2013, 2:13 pm

    Fantastic article. How do I gain an honest P/E of a tech company who’s software is just coming to market, but it’s made losses to date and not projected to Break even for 18 months. The future after this is roughly £4.3m profit accumulation year in year? Real confusion kicks in when trying to find comparable’s.

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