The New Cheap - Why your stocks may be more expensive than you think…
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 the mean is far more representative of the average for stocks. One must be extremely careful when using the mean as the set of PE ratios is so inherently skewed to the upside by occasional massively high outliers such as Torotrak (on a consensus fwd PE of over 2000) and the 25 other stocks on a fwd PE of over 100! As a result the mean of the UK stock market is currently 22x forecast earnings which is extremely and entirely misleading as 90% of stocks have a PE ratio less than 22x! What kind of average is that? It’s just Lies, Damn Lies and Statistics.
In this environment many other standards of valuation need rethought too. There are reams of investors who started out by reading Jim Slater and Peter Lynch and learnt to salivate over stocks that trade on PEG Ratios of less than 1. But now a PEG 0.8 appears to be average for the market? What’s going on are stocks enormously cheap or are we out of our depth?
Special Offer: Invest like Buffett, Slater and Greenblatt. Click here for details »
The new reality of Sideways Markets
I’ve been reading a great little book called “The Little Book of Sideways Markets” by Vitaly Katsenelsen. The book explains the real nature of long term stock market returns and the current environment we are in very well. He shows how the majority of long term secular bull market returns are driven by PE expansion (such as the bull that peaked in 2000). But the market environment for 15–20 years after these bull market peaks are necessarily ‘sideways’ in character as the PE multiple contracts back to normality and then lower.
The market doesn’t need to fall in order for the PE ratio to fall - earnings per share can rise while the market stays flat - which is entirely what we’ve seen since 2000 (with some hairy rides in between!). Kitsanelsen expects the current sideways market to continue for up to another 10 years. Sideways markets such as the one we are in radically reduce valuations across the board until they reach such lows that broadsheets and business journals end up printing headlines such as ‘The Death of Equities’. Normally the stock buying public quits in disgust. Perhaps we aren’t at that point yet - but what this means is that throughout a sideways market you need to constantly recalibrate your expectation of what 'cheap' means especially as PE multiple expansion is rarely a key driver of returns.
Where can you measure your stocks against genuine market averages?
We rank every day the valuations, yields and growth rates of every stock in the market against both their sector peer group and the market as a whole and publish accurate and objective medians alongside these statistics. The kind of visibility this gives investors as to the true nature of their stock valuations is unparalleled on UK websites. Not only that but our ‘traffic light’ system for ranking stocks gives an immediate colour coded visual clue to the relative valuation of these statistics. You can learn more about our traffic light system here. So the next time you are feeling itchy to buy a stock that is looking ‘cheap’ on 15x earnings it may be time to recalibrate your mental counterbalance!
PS - If you are a journalist and you want some free access to genuine UK stock market statistics, get in touch with me through the messaging system or on twitter . Otherwise if you want to learn more we are offering a 14 day free trial.
but do you know where to look?
Get the most concise synopsis of everything that's been proven to work in value investing. If you like your stocks cheap you've found a treasure trove distilled to under 70 pages.
- How to find ultimate Bargain Stocks with Ben Graham
- How to spot Turnarounds and avoid Value Traps
- From Graham to Greenblatt via Piotroski & Lakonishok
- How to value stocks and set a margin of safety
Disclaimer:
As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.
.jpg)
11 Comments on this Article show/hide all
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.
In reply to JB101, post #1
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.
In reply to JB101, post #3
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!)...
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.
"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, !
median forecast PE ratio of a stock on the UK market is 10.9
is this for the ft100 the all share or what?
................ surely, the most useful value is not the median but the mode?
so, what is the mode?
In reply to schober, post #8
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 !
In reply to JB101, post #1
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.
In reply to Paul Scott, post #10
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.