Towards a better benchmark for market valuations

Taking a three-year view of recent company earnings compared with price may be a more logical benchmark for market valuations, according to a paper from Wainwright Economics in the US. Wainright.pdf

The paper, by Wainwright founder and head of research, David Ranson, points out that the ratio of stock prices to recent earnings per share is a “tricky” basis for estimating whether the market is cheap or expensive.

“Large year-to-year variations in earnings due to recessions or unusual write-offs can create a situation where a high P:E ratio is more a function of abnormally low earnings than of unsustainably high prices,” it says.

“This is confirmed by a strong positive correlation between the simple ratio of price to current earnings and the future growth of earnings.”

The approach developed by Robert Shiller which looks to “cyclically adjust” earnings per share using a 10-year moving average is an improvement, Ranson says, and is widely used by institutional investors.

However, ideally, a ratio of price to normalised earnings should bear no correlation with future earnings growth, even as it serves as a successful predictor of price appreciation, he argues.

And the Shiller ratio still bears a correlation with future earnings growth, albeit an inverse one, which introduces an ambiguity in interpreting the meaning of a high or low ratio.

Currently Shiller’s ratio suggests the US stock market is about 20 per cent overvalued.

“We propose instead a ratio of current price to the median of the most recent three earnings years,” Ranson says. “On this basis the (US) stock market currently is only about 6 per cent overvalued – not significantly distinguishable from ‘fair value’.”

For the full paper, download PDF (EMO-0810) or go to www.hcwe.com.