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6.3. The Price-Earnings Ratio: Past and Future

If dividends do not drive equity prices, or explain only part of their movement, an alternative strategy for analysing market forces is to focus on earnings.

The simplest selection criterion would be to identify companies that have experienced the largest increase in earnings per share (EPS) over the past year. However, performance is not an absolute. It must be related to some standard of comparison. Like dividend per share, EPS ignores relative movements in share price that establish whether a stock's EPS delivers an appropriate return commensurate with risk. The return individual investors earn also depends when they buy. If shares are cheap, long-run returns will be higher. But when they are expensive, they will be lower.

To identify these inter-relationships, you will also recall from Chapter Two that the most commonly used indicator is the price-earnings ratio (P/E). If a share costs £1.00 and the EPS is 10 pence, then the P/E ratio is 10 (the reciprocal of the earnings yield, which is 10 percent). Like the dividend yield, we then compare the P/E ratio of a company with itself over time, its competitors, or the market, to ascertain whether the stock is correctly priced.

For example, throughout 2004 analyst and press reports suggested that British Petroleum (BP) the highest ranked Footsie company in terms of market capitalisation with a P/E of around 20, was overvalued. The average for the oil sector hovered around 17.5, with Shell only on 13.5. By August 2005, the market responded to this information with a price correction and the P/E for BP fell to 17.4. But remember there may be sound economic reasons based on trading fundamentals that explain why a company deserves a higher rating than its peers.

Like dividend yield comparisons, when shares seem expensive it might not always be prudent to sell all of your holding, perhaps only a proportion, reinvesting when price and the P/E falls back to a more reasonable level. To complicate matters further, P/E ratios can rise because earnings fall and vice versa, without any compensatory price movement. This often occurs when shares are not actively traded or overlooked by market participants, particularly financial institutions (a phenomenon termed "institutional neglect").

It is also important to note that P/E ratios published in the financial press are "trailing ratios" that divide a company's current share price by its last reported EPS. They only provide a "snapshot" of recent performance and also ignore future growth

If a company has a ratio that is low compared with its long-term average, competitors, or the market, stocks could be cheap. So, it may be a good time to buy. But if the P/E is relatively high it could be a signal to sell. Unfortunately, we have observed that investors do not always behave rationally. Think about 2000, with the tobacco sector trading on a P/E ratio of just seven and a bubble of sky-high ratios about to burst. If somebody suggested moving out of techno-shares into tobacco, there would have been few takers.

Today with hindsight, a popular valuation multiplier based on stock exchange listings that might have produced a rational decision is the cyclically adjusted price-earnings ratio (CAPE). It accounts for the effect of stock market cycles on profits by replacing the latest reported EPS in the conventional P/E ratio with an annual simple average EPS (say 10 years) adjusted for inflation. The rationale for the CAPE is that irrespective of market volatility and its causation, the market always reverts to its long-term average price (what statisticians term mean-reversion).The CAPE can also be compared over several years using a moving average to look at historical trends and identify the critical point before a current P/E ratio reverts to its mean after a spike or a dip.

So, if future investors were to look back over a decade to 2011-12, which market sector would be undervalued today but promises the best future returns?

To judge by current data, one obvious candidate is healthcare. Compared with an overall long-term average of 15, the global P/E forecast for 2012 is just 10.6. Turning to the American market leader, Johnson and Johnson, since 2000 the company's EPS surged by 186 percent but share price rose by only 13 percent. Its P/E for 2012 was also barely above 10, its lowest level for 20 years. However, analysts are reporting that healthcare in emerging markets, notably China and India, is expected to grow by 500 percent by 2020.

Still focusing on the future, we should also note that current P/E ratios are generally higher for companies with higher growth rates. So, comparisons with non-growth companies can make them appear overvalued. It is also difficult to compare companies with different growth rates.

To overcome these defects, another variant of the current P/E ratio based on stock exchange listings is the price-earnings growth ratio (PEG). It measures the trade-off between a stock's current price (P) the EPS generated (E) and analysts' forecast growth rate (G) by dividing the P/E ratio by G:

Proponents of the measure, such as Jim Slater (op.cit.) and Warren Buffett maintain that the P/E of a fairly priced stock should equal its growth. Thus, the PEG equals one. Based on the time honored strategy of "buying low and selling high" investors should therefore:

Seek undervalued shares where: P/E > G and PEG > 1.0 Avoid undervalued shares where: P/E < G and PEG < 1.0

Summary and Conclusions

Based on the capitalisation of a perpetual annuity, markets have delivered an average annual dividend of six percent over the very long term. Historically, the average P/E for shares listed on western markets has ranged from 10 to 14. However, there is no correct dividend yield or P/E ratio. For example, shares in growth companies may trade on very low yields and a high P/E, but these will reflect investors' expectations that profits and hence dividends and price will all rise. Alternatively, a company may be a "castle built on sand" where profits fail to materialize, fail to cover dividends and share price collapses spectacularly, (think ).

History also tells us that markets always revert to their long-term average price. So strategically, a long-run policy of "buy and hold" could limit your returns, even if you bought cheaply, unless you are prepared to sell fast when markets lose momentum (1987, 2000 and 2007). Tactically, you should also take advantage of short-term price movements. To recapitulate part of stock market law:

The higher the dividend yield, the lower the P/E ratio and the lower the dividend cover: then the higher the financial risk and lower the price of an investment (or vice versa).

Selected References

1. Kindleberger, C.P. and Aliber, R.Z., Extraordinary Manias, Panics and Crashes: A History of Financial Crises, Palgrave and MacMillan, 2011.

2. Gordon, M. J., The Investment, Financing and Valuation of a Corporation, Irwin, 1962.

3. Fisher, I., The Theory of Interest, Macmillan (New York), 1930.

4. Miller, M. H. and Modigliani, F., "Dividend policy, growth and the valuation of shares", The Journal of Business of the University of Chicago, Vol. XXXIV, No. 4 October 1961.

5. Slater, J., Beyond the Zulu Principle, Harriman Press (2011).

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