The New Cheap - Why Your Stocks May Be More Expensive Than You Think…

15th Mar '12 by Edward Croft

11 comments 8846 reads

Famously, people aren’t too good with statistics. Every day in the newspaper you can read stories where journalists distort the nature of the numbers. But when it comes to the stock market it gets worse. It doesn’t appear that anyone has even looked them up. So just to grind my axe early, I’ll take an example that I read in a popular shares magazine very recently.

“If [so and so] hits earnings of 20p it will still only be on a PE multiple of 18x earnings.”

Phrases like this are astonishing. They imply that the author thinks a PE of 18x is normal. It isn’t. Get the idea out of your head right now. Your mind is still stuck in a foregone era. You may be anchoring yourself to the kinds of valuation levels that were normal in previous market environments, before the current wave of deleveraging took hold. Its a mode of thought that could be seriously hazardous to your financial health. Thoughts like these can lead investors to blindly buy significantly overvalued stocks, or hold onto winners way past their sell by date.

I am not for a moment implying that a stock can’t be worth 18x earnings and far beyond (of course it can), so before anyone jumps down my throat its worth asking a question…

What is the average PE ratio in the stock market?

Most investors who have any history in stocks will remember that forecast PE multiples of 30x and greater were pretty normal back in 2000. And back in 2007 20x was still seen as standard for a stock showing any sign of growth. Even today one hears rather inflated ‘average’ PE ratios bandied about in the press perhaps because journalists read a lot of American press where PE ratios are routinely higher.

But the truth is that the median forecast PE ratio of a stock on the UK market is 10.9 . Yes - 10.9. Even after what many publications are calling ‘one of the greatest bull runs of all time’. There are only 17% of stocks that trade above a forecast PE Ratio of 18x earnings. Classifying such stocks as cheap may be wildly optimistic unless they have an extremely hard to breach economic moat and/or extremely sustainable growth prospects.

It should be noted that using the median instead of…

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JB101

15th Mar '12

The price-to-earnings ratio (PER) is overdue for retirement. Its reciprocal---earnings yield (EY)---is well behaved around zero earnings, which even good companies have to report sometimes, when the PER goes mad. Sectoral or market-wide EYs are naturally calculated in the same way: total earnings divided by total market capitalization. If you really must know the market PER, just invert the market EY.

The median PER avoids the arithmetical shenanigans of averaging PERs but is heavily biased towards representing small companies.

A further advantage of earnings yield is that, considered as a value indicator, it goes in the same direction as dividend yield. In the long run, there should be a fairly stable relationship between the two, as payout ratios tend to revert to the mean.

Edward Croft

Good point on the EY JB. Regarding using the median - it is indeed true that it overweights small cap stocks, but on the other hand most individual investors are heavily overweight small caps making it quite appropriate as a barometer of value.

It's not only its behaviour at the margin that makes the PE Ratio limited vs. the earnings yield - the PE ratio takes no account of how much debt a company has. A stock with no debt on a PE of 20 is very different to a stock with lots of debt on a PE of 20... (but not many seem to know that!)

Joel Greenblatt redefines the earnings yield in his book the Little Book that Beats the Market as the Enterprise Value / Operating Earnings. This EV/EBIT defined earnings yield is a better ratio for comparing stocks with different levels of indebtedness than the inverse of the PE.

Isn't your formula for the Greenblatt EY inverted?

Yes, there are different versions of earnings (before or after accounting for exceptionals, goodwill amortization, interest, tax, etc.) and capital (equity with or without debt); but that issue is distinct from whether one likes one's EY/PER sunny-side-up or not.

There is a marked difference between the EYs of the FT-SE 100, 250 midcap, small-cap, and fledgeling companies. This is an interesting matter that deserves to be looked at explicitly. Singling out the EY of a fledgeling company a bit above middle rank (with respect to EY) is a somewhat arbitrary way to draw on these data.

Yeah JB - that's definitely a Homer Simpson moment. I meant EBIT / EV...

We've looked extensively at averages... it's a minefield... you'd be amazed at the stats that come out when you use skewed data sets. Admittedly, the best kinds of comparisons are like for like, but then again narrow definitions of relative valuations can lead you off the edge of the cliff (look at what happened to dotcoms in Y2k!)...

UK Value Investor

19th Mar '12

The 'sideways' book gets a thumbs up from me, although I haven't read it. I've been meaning to buy the extended version, 'active value investing'. Hopefully it will expand nicely on his ideas that are in a 20-page PDF he put out some years ago. He nicely sums up the right way to view index levels and investor returns, which is as the sum of various factors, including earnings growth, dividends and changes to valuation measures like PE (or more sensibly something like PE10 if you're looking at an index).

If beginning investors understood markets as the sum of those factors then they might have a more accurate picture of what returns they're likely to get. They wouldn't just look at price growth like in the 90s and assume that we were going to have 20% annualised growth until the end of time.

They might say, wow it's 1999 and these valuations are really stretched to their historical limits and mean reversion theory suggests that they're likely to mean revert which would cause a massive bear market so perhaps we'd better hold more cash (although I doubt they'd use those exact words).

Although I fear that the reality of holding cash while everyone else was getting 20% annualised returns (until the bear market of course) would be too much and my imaginary investor would cave in and put his pension in the NASDAQ or something.

corrsfan

19th Mar '13

"Although I fear that the reality of holding cash while everyone else was getting 20% annualised returns (until the bear market of course) would be too much and my imaginary investor would cave in and put his pension in the NASDAQ or something."

undoubtedly then having lost a good chunk of it, leave the market with a bad taste, then make the next big mistake of not investing when it was cheap after the bubble bottomed out, !

schober

21st Mar '13

median forecast PE ratio of a stock on the UK market is 10.9

is this for the ft100 the all share or what?

22nd Mar '13

................ surely, the most useful value is not the median but the mode?
so, what is the mode?

Schober - this is an article from last year - you can check Median ratios from Stock Reports and we'll be publishing median PE/Yields for all FTSE indices within about 24 hours - bunch of new features coming out.

We don't calculate the mode as it's frankly pretty meaningless for distributions like PE Ratios that are decimalised numbers. If I'm wrong there do let me know.

Our preference is to look at medians. Means are heavily skewed by outlier data. We winsorize our distributions when calculating means to minimise the outlier impact. There's also the question as to whether its worth market cap weighting averages.

The more you get into this stuff the more you realise it's all Lies, Damn Lies and Statistics I'm afraid !

Paul Scott

Hi JB,

I'm glad you posted those thoughts about Earnings Yield (the reciprocal of PER), as I have long thought that Earnings Yield is far more useful & intuitive than PER - as it's directly comparable to other asset classes, and dividend yield.

It would be interesting for older members to perhaps explain why it was that EY was dropped in favour of the more fashionable PER, which I think happened in the 1970s or 1980s?

Perhaps here on Stockopedia we could lead a return to using the more useful Earnings Yield instead of PERs?!

Cheers, Paul.

Paul - Dave and I did go back and forth a lot about this when constructing the Stock Reports. I really wanted the EY on there, but the PE is more popular and Dave (coming from a private equity background) thought we needed to balance the shareholder metrics with EV/EBITDA which is probably more often used by buyout companies who want a proxy for cashflow to finance e.g. leveraged buyouts.

In future we'll offer customisability - i.e. popup to change the ratios.

The New Cheap - Why your stocks may be more expensive than you think…

What is the average PE ratio in the stock market?

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Edward Croft

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