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The price-earning ratio don’t tell the whole story on sharemarket valuations

Price-earnings ratio don’t tell the whole story on sharemarket valuations

There are all sorts of techniques for valuing the sharemarket overall. But at its simplest level, if the economy is growing and companies are generating revenue and profits, this should be reflected in share prices. And the aggregation of these share prices comprises the market.

If earnings results are better in some companies than other companies, this exposes buying opportunities for investors – that is, some companies are regarded as “cheaper” in relative terms.

So shares are no different from residential property or other assets. A property buyer is constantly weighing up relative value – comparing the features of a home with similar properties in the same area. And certain suburbs may be more favoured than others so the property is not only assessed in terms of value in the suburb but suburbs are assessed in relation to other suburbs. Of course, this can be taken further to an assessment of value across regions and even nations.

Shares offer much more flexibility in this regard. Just like property, the relative value of individual companies is compared. And then there are comparisons across sectors, say financials with resources; and then comparisons across countries. In other words, do Australian shares offer better value than US shares? And a raft of other factors comes in here, such as exchange rates.

Shares also differ from residential property in that shares are an investment whereas property buyers may be interested in the asset as a place to live as well as an investment.

And when it comes to investments, it is not just current factors that are taken into account but some assessment of future returns. So for shares, the investor may conclude that current earnings of a company are pretty good but the outlook is far from rosy.

Competition may be heating up, a company’s strategic vision may be doubted and there may be questions about future legislation and the impact on the company and its industry.

And also when it comes to investments, individuals are not just looking at the asset, such as shares, but making comparisons across asset classes. And this is where the field of factors to be considered expands mightily. Still, sticking with shares, there are a range of valuation methods.

One of the simplest is comparing share prices with the latest earnings results – the price-earning ratio or PE ratio. And this simple measure can be complicated further by using some assessment of future earnings instead of current earnings.

Clearly that induces more subjectivity in the measure and it does require a number of analysts to be providing earnings estimates – something that only exists with the bigger companies.

The historic PE ratio (uses current earnings) for the All Ordinaries has been in existence for over 40 years.

Over those 40 years, the assessment of “fair value” has changed a lot. In the 1970s, the average PE ratio was just 7.5 – that is, share prices on average were around 7.5 times earnings. Over the past 20 years the PE ratio has averaged just short of 16. The decade average is lower at 14.3 but, since late 2012, the PE ratio has averaged around 16.

The average or so-called normal PE ratio has varied in line with a raft of factors such as interest rates, relative returns on other assets and perceptions about whether shares are “risky”.

In March the price-earning ratio stood at 16.4, so did that suggest that the market had become expensive? As shown by varying averages for the PE ratio over time, it is not a simple question. But the PE ratio was at 15-month highs and above both decade and 20-year averages. And coupled with other developments such as rising bond yields across April, the short-term outlook for shares had indeed become cloudier.

Valuations are always important but tools such as PE ratios don’t provide all the answers; rather they act as warning bells for investors to make further inquiries.

Written by Craig James

Craig James

Craig James is chief economist at CommSec.

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