Valuation is key to making investment decisions. Invest when markets are expensive and future returns are likely to be poor over the medium to long term. Buy when markets are cheap and the odds are stacked much more in your favour.
But a word of warning – valuations are useless at predicting stock market behaviour over short time frames when fear, greed and other noisy factors tend to dominate.
When considering equity valuations there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit.
A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stock market’s value or price by the aggregate earnings per share of all the companies over the next 12 months. A low number represents better value.
An obvious drawback is that no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.
This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting. However, the past 12 months may also give a misleading picture.
This is particularly true if earnings have slumped but are expected to rebound. For example, UK equities are very expensive on this measure at present, partly because of past commodity price declines and the UK market’s large commodity exposure.
However, commodity prices have rebounded amid an expectation of a profit rise this year. The UK therefore looks very expensive on a trailing P/E basis but less so on a forward P/E basis.
The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.
This attempts to overcome the sensitivity that the trailing P/E has to the last 12 month’s earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.
When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive.
The price-to-book multiple compares the price with the book value or net asset value of the stockmarket. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.
A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.
However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world.
The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns.
A low yield has been associated with poorer future returns.
However, while this measure still has some use, it has come unstuck over recent decades.
One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price).
This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth.
A few general rules
Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stockmarkets mean that some always trade on more expensive valuations than others.
For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.
One way to do this is to assess if each market is more expensive or cheaper than it has been historically.
We have done this in the table below for the valuation metrics set out above.
We show in each case the valuation multiple for each region. We also show in brackets the average (median) of the past 10 years.
Cells are coloured green if the market is cheap compared with its 10-year average, amber if neutral and red if expensive. All figures are as at 30 April 2017.
Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future.
Equity market valuations versus 10-year average (medians)
At the end of April, the UK was trading on a CAPE multiple of 14 times compared with a 10-year average of 20 times. It is therefore very cheap on this basis.
However, both the trailing and forward P/E are more expensive than their 10-year averages whereas the market looks more neutrally valued on a P/B and dividend yield basis.
On a longer term basis, the UK overall comes out relatively neutral overall. Valuations are unlikely to be the key to performance with Brexit, sterling and commodity prices meriting closer attention.
As far as valuations are concerned, it is difficult to see anything but tough times ahead for the US market in the long run.
However, as this market also has the strongest economic growth and could benefit from President Trump’s mooted taxation changes, it could be argued that it is a gem in a world of disappointing prospects elsewhere. Reassuringly expensive you might even say. It would take a brave investor to turn their back on the US entirely.
Europe too, after a decent run, has moved into expensive territory whereas valuations are more favourable in Japan. Japan’s price/book ratio of 1.3 times would be considered exceptionally cheap in any other market.
However, Japanese companies have historically been notoriously inefficient. This has led investors to justifiably value them at a discount relative to other regions such as the US on this basis. This is a good example why care needs to be taken when making cross-country comparisons.
Emerging markets have experienced an upturn and recovered some of their lost ground but also continue to offer some attractions. They are slightly expensive on a trailing P/E basis but are otherwise positioned quite favourably, at least in relative terms.
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