Pros and cons of stock market valuation measures

Pros and cons of stock market valuation measures

Investors can turn to many different measures to consider stock market valuations. Each tells a different story. They all have their benefits and shortcomings, so a rounded approach that takes into account their often-conflicting messages is the most likely to bear fruit, says Duncan Lamont, the head of research and analytics at Schroders.

Forward price-to-earnings multiple (P/E)

We divide a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number represents better value.

An obvious drawback of this measure is that it is based on forecasts, and no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.

Trailing P/E

It works in a similar way to the forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E, this involves no forecasting. However, the past 12 months may also give a misleading picture.

Cyclically adjusted P/E (CAPE)

This attempts to overcome the sensitivity that the trailing P/E has to the past 12 months’ earnings by instead comparing the price with average earnings over the past 10 years with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.

When this is high, subsequent long-term returns are typically poor. One drawback is that it is a bad predictor of turning points in markets. The US has been expensively valued on this basis for many years, but that has not hindered it from becoming ever more expensive.

Price-to-book multiple

This compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.

A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.

However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world.

Dividend yield

The income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns.

Although this measure still has some use, it has come unstuck in recent decades. One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps to push up the share price).

A few general rules

Investors should beware the temptation simply to compare a valuation metric for one region with that of another. Differences in accounting standards and the make-up of different stock markets mean that some always trade on more expensive valuations than others, says Lamont.

For example, he says, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere such as Europe.

When assessing value across markets, we need to set a level playing field to overcome this issue.

Lamont says that one way to do this is to assess whether each market is more expensive or cheaper than it has been historically. This has been done in the table below for the valuation metrics set out above. However, this information is not to be relied upon and should not be taken as a recommendation to buy and/or sell.

“Investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is this case with any investment.”

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