By Duncan Lamont
When considering whether a share is overpriced, underpriced, or selling at fair value, 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 generally a good idea.
A common valuation measure is the forward price-to-earnings multiple (P/E). We divide a stock’s value or price by the expected earnings per share of the company over the next 12 months. A low number represents better value. An obvious drawback of this measure is that it is based on forecasts and 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.
The cyclically-adjusted price to earnings (CAPE) multiple is another key indicator followed by market watchers. This attempts to overcome the sensitivity that the trailing P/E has to the last 12 months’ earnings by instead comparing the share price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings. When this is high, subsequent long-term returns are typically poor. One drawback when applied to a stock market as a whole 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 company’s share price with its book value or net asset value. 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 share 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.
A few general rules
Investors should beware the temptation to simply compare a valuation metric for one region, sector or company with that of another. Differences in accounting standards and the makeup of different stock markets 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 sizable 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.
Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is the case with any investment.
Duncan Lamont is head of research and analytics at Schroders