PE & Prospective Returns

Last week we had a look at a pretty reliable ratio that looked at a shares market capitalisation and how this could be used to identify periods of over and under valuation. This week we have been looking at some more, primarily the PE or Price to Earnings Ratio  that is widely used  throughout  financial services.

The PE ratio is derived from the current price divided by the earnings per share (EPS) , so if the price is 100p for a share and the earnings per share the company has generated 10p then the PE Ratio is 10.This means that investors are willing to pay 10 times the annual earnings for a share; a higher share price 200p and the same EPS would  by 20 - similarly a decline in EPS would also see the PE Ratio rise .

Conversely the tried and trusted strategy of buying a share with a low PE Ratio, caused either by a falling share price or decline in Earnings Per Share when  investors perceive  the shares prospects to be poor has often yielded positive results.

The PE ratio is not perfect lots of things can alter the value of a share and the earnings per share, from negative sentiment to  one off events that effect the earnings for a year; however it is useful to see where  we  are in comparison to history.

In this instance rather than look at an individual share we thought we would construct an average from some of the larger companies (based on market capitalisation)  in the FTSE-100 to see if this would give us any clear indication of market direction.

We used 25 different shares across 19 different sectors that have all had a wide and varied history over the last 20 years or so. The  graph below shows how the PE peaked in 1999/2000  and is currently higher than 2007/2008 market  high. 

The following graph shows the percentile rank for the PE e.g. 90% means that the current level is in the top 10% of high readings of the period analysed. We then overlaid a graph of actual 5 year annualised returns (inverted) from the FTSE 100 which shows  quite a close correlation and suggest that we should not be expecting too  much form the index.

Q Ratio

This is a ratio devised by James Tobin Yale University in the late 1960’s and looks at the total value of a firm on and the total value of its assets - in its simplest for the ratio is calculated as follows:

Q Ratio = Total Market Value of a Firm

Total Asset Value

So if a firm has 100m shares and a price of £2.75 is has a market capitalisation of £270.5 million; this is the total market value of a firm i.e. what investors are willing to pay for ownership of a share of a Company.

If the total assets of the same Company - this includes all things such as property, equipment, cash at the bank etc - is £200m then the Q Ratio for the company is

Q Ratio = £270.5m     = 1.35

£200m

The market is valuing the Company at 1.35 time the cost of its assets; if this ratio was less than 1 then the market could potentially be undervaluing the Firm.

This ratio can be applied and interpreted in many ways; it can be used to assess a Company, a sector or the market has a whole. To use the ratio effectively as a gauge its important to understand how changes in the numerator and the denominator  effect the ratio—for example market speculation and aggressive stock buying can increases the market value raising the ratio. When it comes to total assets what’s not included? Things such as brand name and intellectual property (intangibles) are difficult to value and a high Q ratio could be justified because of the value of these items that do not make up the total assets.

As with any indicator the best thing to do is test it! Over a decent period of 10 or more years……...

The graph below shows the Q Ratio (blue) of a share we looked at recently, the red graph is inverted and shows subsequent three year returns - the patterns are fairly similar and since 2004 a high Q ratio led to disappointing returns over the next 3 years whereas the low Q Ratio in 2009 set the scene for a excellent returns. In late December 2013 the ratio peaked at 1.30 and provided an early warning indicator as the next 40 days saw the price decline by almost 25%. As with all indicators its not perfect, and we never rely on one alone.

Buy & Hold?

With the recent declines - and especially if we see them continue - the advocates of “buy and hold” will soon be telling us “Stay invested” and “Don’t miss out on the  best days of the recovery by selling your equities “

Now I think buying investments and holding them for a long time is a great idea, however I don’t feel that you can just decide to buy at any point and be assured of the average return. I read an article recently providing facts and figures on how 3 month falls were typically followed by strong rebounds in price (often over 20%) and that missing the best 10 days of the market reduces returns by up to two thirds.

This may well be the case if you are in it from the very start but try telling it to some one who invested at the market top in 1999 or 2007 and have only recently broken even on that investment 15 or 7 years   later respectively.  No doubt returns are reduced by missing some of the best days but what if you were prudent and missed some of the worst? Capital preservation stops you taking on too much risk to try and recover your losses, here’s the maths -

· £100 invested  and lose 30% you have £70, a return of 43% (£30/£70) gets you back to £100

· £100  invested and lose 15% you have £85, the same 43% return gets you to  £121 a gain of 21%

Out of interest  we looked at the 1999 FTSE 100 top and there were two declines in 1998 and 1999 where 10% or more was lost and  the market  recovered  those losses and made gains— but the lost over 50% over the next three years! 

Look back further and in 1929/30 the US Dow Jones Industrial fell over 40% then recovered rising over 47% from that low (still over 50% what it was originally worth!) before falling again 85%. We can never say with any certainty what is going to happen but always have a look at history and consider where you are in relation to the average—buy and hold is a great strategy but only if you decide to use it at the right time.

Rough Week!

This month has seen equity markets Globally, and Europe in particular, move sharply lower for a number of reasons  but it appears clear there has definitely been a reversal in sentiment.

The Bank of International Settlement (BIS) tells us to expect more volatility in a recent article in the Telegraph

Economic Sentiment & Equity Markets

Economics and equity markets are not always closely linked but in Europe what happens in German can have a pronounced effect. Take a look at the ZEW Indicator of Economic Sentiment  in Germany (bottom graph) and how it is closely linked to the German and wider European  Stock Markets (top graph) .

We explore this and a few other areas in our Weekly Round Up on our website 

Volatility and the FTSE-100

We have previously looked the how low volatility can be a good "contrarian" indicator where low volatility suggests that investor sentiment may be too buoyant (When High Risk Can Mean Low Risk). 

Well the last couple of weeks we have seen volatility on the rise for the FTSE-100 as the widely watched UK Index declined. 

You may notice the almost mirror image - well if we overlay FTSE 100 with the Volatility Index (turned upside down) you can see the similarities and we will wait to see if the FTSE 100 follows volatilities lead.

Tough Times for Food Retailers

The top graph shows how Tesco, Morrison’s and Sainsburys have been having a pretty tough time—Tesco had already been suffering after their announcement faux pas -  however was the always likely? The lower graph is an extract from a review that we undertook on the sector in March and shows how total net profits for the sector were in decline after 4 years or growth (red bars) even more worrying is the blue line that shows the net profit for these companies in the sector weighted by their market capitalisation i.e. more emphasis on the larger firms.