Wednesday, 16 October 2013

Are shares still too cheap?

Until we discover whether US lawmakers will reconcile their differences there is little to do so I thought it might be fun to reflect on theory. Specifically the theory of valuing shares.

Put very simply a share is best valued by measuring its PE ratio. This compares its price with its earnings per share (Price/EPS=PE).  The reciprocal of the PE is known as the earnings yield (EY) and can be compared directly to the dividend yield on a bond. However there is more risk involved in a share's earning yield because earnings are not guaranteed from one period to the next and they may fall or rise abruptly. Long tern investors look for shares whose earning per share have a long record of steady increase. Owning these shares has an advantage over bonds because the yield will rise over time.

A bit of an example should make things clearer. Lets imagine a company that makes a variety of foodstuffs and call it Munch Incorporated:

  • It has a share price of $20 and its earnings per share are $1. 
  • Its PE ratio is 20 (20 divided by 1) 
  • The reciprocal of this is 5% (1 divided by 20 is .05, multiply this by 100 and you have 5%) 
You can compare this to the yield on bonds which may be 3.5%. Lets say that Munch has had an unbroken record of increasing its Earnings per Share (EPS) by 10% per year and you can see that the premium which investors expect for owning a share with its inherent risk is the 1.5% difference between the yield on shares compared with bonds.

If we take an average of all shares on the market and look at the movement of their PEs we capture the movement in several measures

  • Movement in bond yields. If bond yields fall then unchanging EY will begin to make shares look more attractive so prices will rise to bring EY back into line
  • A general rise in earnings prospects brought about by, for example, a strong economy will shift sentiment and raise the expectation of earnings and EY in future. This anticipation will raise prices and reduce EY until the improvement in earnings become a reality
  • Extra cash coming into the stock market because of the printing of money or because investors become over exuberant about earnings prospects will all raise prices and reduce EY
I prefer to think about EY than PE because a 5% yield is easier to understand and compare than a 20 or 25 PE (25 is equivalent to 4%). The relationship between the two is unchanging. Here is a part of the run of ,the relationships.

           PE       EY %
7 14.3
8 12.5
9 11.1
10 10.0
11 9.1
12 8.3
13 7.7
14 7.1
15 6.7
16 6.3
17 5.9
18 5.6
19 5.3
20 5.0
21 4.8
22 4.5
23 4.3
24 4.2
25 4.0
26 3.8

So what has been happening to PE ratios over time? Robert Schiller has made a study of this and has calculated his own version of PE ratios over time. He adjusts earnings for inflation and takes a 10 year average to compensate for cyclical movements. His calculations result in a graph shown below.

We are currently at quite a high level with prices pushed higher by excess demand generated by QE. However, it is hard to argue that an above average PE is simply a bubble. The returns on bonds are very low so a lower level of EY is not particularly surprising. A PE of 24 is equivalent to a to a yield of 4%. A rise in bond yields would, however shift the goal posts. A rise in interest rates, which could follow a US debt default could trigger a sudden fall in PE ratios with share prices falling to offer better earnings yields.

The following chart shows the movement of unadjusted PE ratios. This shows the current PE to be about 19 (EY equivalent 5%) compared with the average of 15. Again the figure is high but it does not look outrageous. 

1 comment:

David Goyder said...

Love your master classes even if it is just to go over what we should all know. Your pixie dust analogy is so true, the US debt is $53,000 for each man, woman and child and I have an American granddaughter!! The real question ius when do we go to cash to ride the next downturn?