Interpreting the messages in P/E ratios

Investor: An insider's guide to the marketIn the aftermath of the increase in volatility experienced in stock markets in recent weeks, it pays to try to go back to basics and to place current market levels and valuation ratios in a historical context.

The business of financial analysis and share price valuation has become highly complex and sophisticated.

Stock market research often comes with a bewildering array of numbers, financial data and statistical analysis. Despite such advances, many investors, both professional and private, continue to rely on the two traditional valuation yardsticks of the dividend yield and the price earnings ratio (P/E).

The latter is probably by far the single most important ratio applied to assess whether a share or an overall equity market index is "fair value", "expensive" or "over-priced".

It is worth reminding ourselves what this ratio actually consists of. The "P" is simply the share price or the overall level of an equity market index. Below the line, the "E" is the after-tax earnings generated by a company or, in the case of an index, the aggregate after tax profits generated by the index constituents on a per share basis. Therefore, a high P/E ratio means that the share price is high relative to earnings.

Ideally investors should be aiming to buy stocks when the P/E is low and sell stocks when the P/E is high. At the aggregate market level, a very high P/E ratio can be an indicator of an imminent market peak and a subsequent bear market.

The reference point for judging where a market is relative to "fair value" is usually taken as some long-term historical average value. For example, the long-run P/E for the Standard & Poor's 500 is approximately 15, which is about where the US market is currently trading. The story is similar for most global stock markets where market P/E ratios are in general close to long-run historical averages.

The implication of this is that equities are currently priced at a level which should deliver superior long-term returns as long as economies continue to grow in a low inflationary environment.

In fact, some analysts argue that the next phase of the bull market will be driven by an expansion in P/E ratios. Typically, as bull markets mature, the P/E ratio rises significantly above the long-term trend as investors become increasingly optimistic and purchase shares at ever-higher P/E ratios.

Historical precedent is definitely on the side of this analysis - bull markets rarely end at times when P/E ratios are trading close to long-run averages.

However, great care needs to be taken in interpreting the messages given by P/E ratios. Despite its widespread popularity and usage, it is an extremely imprecise indicator of value and is not in fact theoretically well grounded. It is an identity, the interpretative value of which depends entirely on the quality and reliability of the earnings numbers used.

Corporate earnings are highly cyclical and volatile. Most companies are operationally geared and financially leveraged so that modest percentage changes in revenues - up or down - will result in much larger swings in profits.

Therefore, a big drop in profits can quickly turn an apparently low P/E ratio into a very high one as the size of "E" falls.

It is therefore not surprising that equity market levels are very sensitive to expectations regarding company profits. During the recent short and sharp market correction, much comment focused on the role played by the fall in the Chinese market as the catalyst for the sudden falls in share prices. Investor believes that a more likely explanation resides in the US housing market and the growing problems in the US sub-prime mortgage market.

Some analysts take the view that the US housing market will continue to weaken and will eventually be the catalyst for an outright US recession. Even a mild recession would lead to a fall in corporate profits, which would push up P/E ratios.

Of course what would instead happen is that share prices would fall to keep P/E ratios at more normal levels.

In fact the actual fall in share prices would probably be amplified by the tendency of P/E ratios to contract in recessionary conditions.

Corporate profits as a percentage of national income are at record highs in most markets and consequently the pace of profit growth is almost certain to slow down. Bearish commentators argue that earnings as a proportion of national income will have to revert to historical averages at some stage.

In other words they argue that the "E" in the P/E ratio is artificially high and that, therefore, current P/E ratios are giving investors a false sense of security.

While there is merit in this argument, Investor's view is that any reversion to the mean in the profit share of national income would occur over a prolonged period of time and it is impossible to predict when such a trend may begin to emerge. For all its faults, the standard P/E ratio is the best indicator of value available and it continues to signal that equity markets remain good value.

Investor says ...

Aim to buy stocks when the price/ earnings ratio (P/E) is low and sell stocks when the P/E is high... Equities are currently priced at a level which should deliver superior long-term returns as long as economies continue to grow in a low inflationary environment.