Jim O’Neil who is the Chairman of Goldman Sachs Asset Management was recently asked his opinion of the outcome for Greece.
He said the interviewer might as well go to a London Street and ask pedestrians – his point being that no-one knows (so say expert or not).
It’s useful to know what we don’t know (and can’t know) as it avoids wasted time acting on information which is “at best” a guess.
There are however metrics and indicators which will in total give valuable guidance.
One such metric is the Price to Earnings Ratio (PE).
This is a simple ratio which compares the price of a share to its earnings to give a multiple i.e. if share price 1 and earnings 10 then PE ratio is 10.
As a broad brush:
| Less than 10 multiple | Very depressed valuations or company in trouble |
| 10 – 16 | Average for most companies |
| 16 – 30 | Strong growth story |
| 30 plus | Super growth story |
Now the figures below are very broad brush but they do give an indication of where we are now.
From 1900 – 2000 the average PE ratio of the US (S&P 500) index was 15 times. This is to say that shares sold on average for 15 times their earnings over 100 years.
Within this period however the PE ratio average dropped as low as 4.78 in 1920 and went as high as 44.20 in 1999. So in 1999 the ratio was over 300% above its average!
Individual companies
The figures below are the PE ratio’s and dividends of multinational companies of very good to exceptional quality.
| Company | PE Ratio | Dividend |
| AIG (US) | 2.6 | Nil |
| Apple (US) | 13.9(however over $100 billion in cash on balance so excluding this between 10 – 11 and below 10 for coming year) | To be confirmed(circa 2% starting July 2012) |
| Banco Santander (Spain) | 6.10 | 13.11% |
| BP (UK) | 4.88 | 5.38% |
| Legal and General (UK) | 8.96 | 6.48% |
| Microsoft (US) | 10.89 | 2.75% |
| Vivendi (France) | 9.97 | 7.59% |
| Tesco (UK) | 8.31 | 5.38% |
Over the last 20 years the PE ratio has varied enormously:
| 1988 | 11.69 |
| 1991 | 26.20 |
| 1994 | 15.01 |
| 1998 | 32.60 |
| 2000 | 46.50 |
| 2004 | 20.70 |
| 2007 | 22.19 |
| 2012 (24 May) | 14.85 |
PE ratio – predictor of future performance
Work has been done to look at the performance of markets for ten year period after a year when a PE ratio was unusually high or low.
The findings are instructive and really confirm what should be obvious.
Lowest PE Ratio’s (since 1970)
| Year | PE | Subsequent 10 year return (% p.a.) |
| 1974 | 6 – 7 | 16% p.a. |
| 1980 | 6 – 7 | 12% p.a. |
| 1990 | 10 – 11 | 11% p.a. |
| 2000 | 46.50 | -2% p.a. |
Conclusion
The lower the multiple of earnings paid for a share on average the better the subsequent returns will be over the following 10 years.
Investment is most productive when shares prices are low (i.e. low multiple to earnings).
Problem for investors
These times will be periods of anxiety and fear, this has to be so, otherwise prices would be much higher.
Current market distortion
The overall market PE tells a broad brush outline story.
The current PE of 14 appears to be at average levels but because of the FEAR AND FLIGHT TO SAFETY many who want or have to (i.e. equity funds) own shares have very high holdings in companies and sectors which are defensive and less volatile.
Currently therefore shares in sectors such as:
- Utilities
- Healthcare
- Consumer staples
have higher than normal PE ratios because they are in demand.
Conversely shares in more cyclical sectors have much lower than average ratio’s. This can be seen in sectors such as:
- Mining
- Financials
- Industrial
- Construction
Using the proven investment method of “mean reversion” (i.e. things move above and below long term average metrics but will return to the average) these sectors and the best companies within them are likely to produce strong returns as and when some level of normality returns.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.