This article was first published in the third-quarter 2012 edition of Personal Finance magazine.
One of the most fundamental considerations when deciding to invest or not invest in a share is the price-to-earnings (p:e) ratio. It tells you a great deal.
The p:e ratio is calculated by dividing a share’s price by its annual per-share earnings (profits). A higher ratio suggests a stock is expensive, and a lower one suggests it is cheap, relative to its profits.
It is a rough guideline that many investors, including large institutional investors, seem to have ignored in the horrible listing of social media network Facebook on the Nasdaq exchange in May.
When Facebook set its initial public offering price at US$38, the price was high – more than 100 times its p:e ratio based on profits of the previous year. Even after the first two days of trading, when the share price dropped from $38 to $31, the p:e was still high, at 85 times earnings a share.
In simple terms, this means it will take 85 years at current profit levels to cover the initial cost of the share.
The Nasdaq composite index of technology stocks trades at 15.7 times last year’s earnings, according to FactSet, a provider of financial data. Apple trades at 13.6 times and Google at 18.2 times.
P:e ratios can be based on historical figures or on anticipated profits. When a p:e is high, the justification for purchasing the share is that the company is expected to grow at a rapid rate, and with it the profits. The growth in profits at Facebook is expected to come from growth in advertising revenue.
The US$31 share price implies a forward p:e of 60, compared with Google’s 13.3 forward p:e (for a similar rate of growth).
As p:e ratios often seem to be ignored when buying into an expensive share or market, so they also seem to be ignored when there are bargains on offer.
This is highlighted by overall markets in May.
The first two weeks of May were not pleasant for equity investors across the globe. The FTSE/JSE All Share index (Alsi), which was at its peak on May 2, had shed 2.9 percent by mid-month.
When the Alsi was hitting record highs, the historical average p:e rose to almost 18, which is way above the 20-year mean of between 14 and 15, about where it was back to by early June.
Paul Stewart, head of asset management at Grindrod Asset Management, says the reason for the sell-off was that investors focused on the mess in Europe and the negative knock-on effect of this situation on economies across the globe. Investors were asking “whether we are once again entering a bear market”.
It is in situations such as this that it is worthwhile having a look at historical p:e ratios.
The top graph of Chart A (links to the charts are at the end of this article) shows the trailing p:e ratio of the Alsi at the start of all bear markets (defined as a drop of 20 percent or more) on the JSE since 1960.
Stewart says the average p:e ratio of the Alsi at the start of a bear market has been 15.6 times earnings (the red line in the graph).
“Since 1960 there have been six bear markets where the Alsi traded below this average p:e. There have been only two bear markets (orange bars) since 1960 when the p:e ratio at the start of the bear market was below the long-term average p:e of 11.9.”
The bottom graph of Chart A shows the percentage decline of the Alsi during these bear markets.
For the two bear markets (orange bars) that began when the Alsi was trading below the long-term average of 11.9 times earnings, the average decline was 34.3 percent.
“While this is below the historical average decline of 38.6 percent, the sixth most severe bear market on the JSE since 1960 began in October 1980, when the Alsi traded at a mere 9.1 times earnings. That bear market lasted a full 24 months and saw a decline of 38.7 percent,” Stewart says.
“While the Alsi p:e ratio helps us to compare the market’s valuation over different time periods, it also helps to compare the market’s historical valuation relative to alternative assets.”
The top graph of Chart B shows the earnings yield of the Alsi relative to the 10-year yield on the BEASSA All Bond index (Albi) on the specific bear market starting dates.
Stewart says: “As of April 30, 2012, the earnings yield of the Alsi at 7.7 percent was slightly below the yield on the 10-year treasury bond of 7.8 percent (relatively speaking, at 0.99 on the chart). Since 1965, the date from which the yield data for the Albi is available, there has only been one bear market that began with a ratio higher than one.
“Historical valuations of the equity market at the start of bear markets since 1960 show that although bear markets are less likely to occur when valuations are at low levels, they are still possible. While valuations remain attractive, there are many other potential variables investors need to take into account in their investment decisions.”
Stewart says that while an underweight position in equities seems to be the right strategy for now, with uncertainty and volatility likely to continue for some time to come, he believes equities still have the best return potential over the long term compared with other asset classes, such as cash and bonds.
“Long-term investors who can tolerate the volatility should therefore not abandon their equity positions in times like this,” he says.