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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 [2].

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 [8] 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 [9] 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 [10] 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.

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 [11] 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 [12] 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 [13], 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 [14].

Series NavigationValuing the market: Are shares cheap? [2]The cyclically-adjusted P/E ratio (PE10 or Shiller PE) [3]