# What is the correct p/e ratio for stockmarkets?



## Brendan Burgess (19 Feb 2002)

Fair criticism has been made of my "stay invested in equities at all times" recommendation in The Guide. I do believe that it is the correct long term strategy and I also believe that it is probably impossible to time the markets. But a few  questions arise:

If the S&P is overvalued at the moment, what is the correct valuation? 
What is the correct price for the ISEQ?
Should an investor try to identify low risk shares?

<!--EZCODE BOLD START-->* What is the correct valuation for the S&P?*<!--EZCODE BOLD END-->
It seems obvious in retrospect that at a p/e ratio of 32 the S&P was overvalued. It seemed obvious at the time that the Japanese stockmarket was overvalued with a p/e of 80. It also seemed obvious at the time that technology stocks were overvalued when they were valued at multiples of turnover. 

But is there a correct p/e ratio for any market? The long term historical p/e for the S&P is about 15. Does that mean that any valuation above that is too high? I don't think that there can be a <!--EZCODE ITALIC START-->_ correct_<!--EZCODE ITALIC END--> p/e ratio. The ratio must reflect the prospective long term earnings and the prospective yield on bonds. 

So rather than try to identify a correct p/e ratio, should an investor try to identify an upper limit whereby investment in the stockmarket is getting very risky? Let's take a p/e of 25 for example. If a stockmarket exceeds 25, then it has to be risky. It's not necessarily overvalued, but the degree of risk must be a lot higher. Stockmarkets fluctuate between overvaluation and undervaluation. A stockmarket which rerates from 25 times earnings to say 12 times earnings, loses 50% of its value. 

<!--EZCODE BOLD START-->* What is the correct price for the ISEQ?*<!--EZCODE BOLD END-->
While the American and European stockmarkets may have been overvalued, the ISEQ seemed to be much better value with a p/e of around 15. 

So was my simplified advice to buy the top 10 Irish shares correct by accident? Irish fund managers are under pressure to switch from fairly valued Irish shares to much more expensive Eurostoxx. This advice seems as lazy and misguided as my advice to buy only Irish shares. 

<!--EZCODE BOLD START-->* Should an investor try to identify low risk shares?*<!--EZCODE BOLD END-->
Here are the p/e's of the some of the top Irish quoted shares:
Iona…………..204
Smartforce……..63
Ryanair…………34
Power Leisure ….31
Riverdeep….…26
Galen…………24
Icon…………..24
CRH………….16
IAWS…………16
Bank of Ireland.13
Elan……………10

Total market …..13.6

The market is very efficient and it is impossible for most of us to identify overvalued and undervalued shares. But could we apply a filter to reduce our exposure to high risk shares? We may accept a reduced return in exchange for this lower risk.

Again, I must stress that by risk I mean the potential permanent loss in value and not the volatility of the share.

I am not trying to say that Ryanair is overvalued at 34 times earnings. I am just saying that it appears riskier than Bank of Ireland at 13 times earnings. 

I understand that the main reason for the decline in the Eurostoxx has been the crash in shares such as France Telecom, Deutsche Telekom and Telecom Italia. France Telecom is still valued at 84 times earnings and Deutsche Telekom, I think is loss making. 

Could we devise a simple rule: "Don't buy when the p/e is over 20 and sell when the p/e is over 30".


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## d53 (19 Feb 2002)

*Correct p/e*

I'm no economist, but I don't think you can talk about a min or max p/e: the question is not what its value is, but is it appropriate.

The two variables that determine the value of one company's p/e relative to another are the expected rate of profit growth and the discount rate.  If the discount rate being used is 10%, say, and company A is expecting no future profit growth, and company B is expecting 5%, then B's p/e ratio should be double that of A.  This doesn't mean you should buy A and sell B.  However, if you feel that the market is underetimating A's future profit growth or that the estimate is not taking account of the riskiness of B's profits, then there are buy or sell messages.

The above is simplification: another important variable is tax: the lower the expected tax rate, the higher the p/e.  Also, its easier to talk about relative p/e rather than absolute values.  But I don't think you should set a max or min p/e.

d


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## corncrake (19 Feb 2002)

*PEs*

Brendan- I think you are straying onto dangerous ground.

Firstly, you seem to be highlighting the apparently better value in the ISEQ in an effort to support your 10 stock 'strategy' .At a time when we can access a broad range of non-Irish shares I find the advice to stay at home bizarre  (I have already posted this view).

To an investor dealing in any kind of half-reasonable size (like yourself!) gross roll-up must make investing through a unit-linked fund/unit trust a more attractive option.Admittedly at a price, the pooled approach provides tax efficiency,avoids dealing with dividends,and most importantly, provides diversification.It also saves small forests in terms of the paperwork which goes out to investors !

Moving on to your PE argument ,you correctly advert to the relationship with bond yields( which obviously move up & down).However you make the following statment afterwards "If a stockmarket exceeds 25,then it has to be risky".

If bond yields were at 3%, a PE of 25 might be exceptionally attractive, especially if there was an expectation of earnings growth( e.g. coming out of a recession).I do not believe that rules of thumb like "don't buy when the PE is over 20 and sell when the PE is over 30" are likely to be very helpful.
A rule of thumb which related bond yields with earnings yields (inverse of PE) might be altogether more useful.In the past decades this would have been a useful guide,though you would have sold a long time before the major sell-offs.

The simplistic comparison between BOI and Ryanair worries me- the higher PE on the latter reflects its significantly higher earnings growth prospects.Ryanair is no dotcom selling us hope value - it has a proven business model which has delivered EPS growth of 23% pa over the last 5 years. Microsoft has looked expensive for most of the last 15 years and notwithstanding its recent travails has been a stunning investment over the long term.

Finally I think you make a very fair point about the pressure being applied to fund managers to switch from Irish shares being 'lazy and misguided'.In so far as it is driven by the need to reduce stock-specific risk it is in my view correct( you seem willing to live with what I would see as a very high level).

The stock-specific risk 'problem' can be dealt with without forsaking the significantly better value which appears to exist currently in the home market.


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## Brendan Burgess (19 Feb 2002)

*Re: PEs*

Hi Corncrake

I wouldn't say that I am straying onto dangerous ground. I am just reviewing my own views in the light of the well informed comments on The Guide. My views have evolved over the years and are continuously evolving. That is a boast, not a confession. 

I am not trying to justify the "Buy Irish stocks" policy. In an effort to simplify things, I said buy the top Irish stocks, without even considering their p/e's and the p/e's of non Irish stocks. (It's accidental that this policy might have been right because Irish stocks don't appear to have been as overvalued as some others - I am not claiming any credit for this)

If I was in America, I would have written "Buy the top American stocks". Worse still, the Japanese version 10 years ago would have said "Buy Japanese stocks". 

Now what I am trying to establish is whether we should try to value the various markets by some yardstick to see which are overvalued. If the Irish market shoots up to a p/e of 30, while the Eurostoxx is at 15, should we switch out of Eurostoxx to buy Irish?

<!--EZCODE QUOTE START--><blockquote>*Quote:*<hr> At a time when we can access a broad range of non-Irish shares I find the advice to stay at home bizarre <hr></blockquote><!--EZCODE QUOTE END-->

I recommended Irish stocks for straightforward convenience. If someone wants me to sell my Irish stocks to buy Eurostoxx, they have to give me some compelling reason e.g. better value or lower risk.


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## corncrake (19 Feb 2002)

*Brendan & the home market*

The single most compelling reason for going outside the home market is DIVERSIFICATION.

 I've made the point before ,but there is (to me) an obvious & compelling logic to not having your investments (& especially pension) too exposed to the home market.

A downturn in the domestic economy which may impair your ability to keep up the contributions(or cause you to draw down on your savings/investments) will be happening at the same time your Fund is shrinking if it is primarily invested at home. 

Very many people with money in Ireland have a significant part of their long term savings/pension invested in property and this is well geared to the Irish economy.I genuinely struggle to see why their non-property assets should also be predominantly Irish( even if as we both believe many Irish shares are relatively cheap).

For what it is worth, my logic seems to have been adopted by the Nation Pension Reserve Fund, which is keeping investment at home to a minimum.

BTW , your response Brendan fails to deal with the substantive issues raised in my last posting.Again I say the rules of thumb you suggest are deeply flawed.

Your example of the ISEQ being on 30x and the Eurostoxx on 15x is instructive in its own right-this type of valuation differential is impossible when we have effectively got the same bond yields across both markets.


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## Brendan Burgess (20 Feb 2002)

Hi Corncrake

You made a number of interesting substantitive points.

My initial idea was "The market is efficient. Don't bother studying shares. Pick 10 at random. You might as well buy Irish shares as they are convenient and tax efficient."

I paid no attention to the current value of markets and various contributors took me to task on that. Now I am wondering if they are correct and I am trying to work out the implications of it. 

Assuming that the market is efficient, I can't say whether or not a p/e of 25 is justified for Ryanair. But there are some indicators or risk in a share. High p/e must be one of these risk indicators. The high p/e assumes a coninued high level of growth in earnings. A p/e of 12 makes much fewer assumptions. 

I disagree fundamentally with all the MPT measures of risk. Risk is a much more fuzzy concept which is difficult to measure. It seems to me that a high p/e share is riskier than a low p/e share. 



Brendan


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## Grundy (20 Feb 2002)

*High P/E = High Risk?*

<!--EZCODE ITALIC START-->_ Boss_<!--EZCODE ITALIC END-->  US Government Bonds are on a "P/E" of c.20.  You can get Junk Bonds with yields of 20% i.e. a "P/E" of 5.  Which is the riskier?


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## The Horse Whisperer (20 Feb 2002)

*Out to Stud??*

Has Sir Ivor been out to stud or something?
Long time no see!!


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## Brendan Burgess (20 Feb 2002)

*Barlo, Unidare etc.*

Coming back to PEs, Barlo, Unidare,Norish and Oakhill were among the worst non-tech companies on the ISEQ in 2001 ( minus 65% on average) but would all have started the year on PEs that by Brendan's logic were consistent with them being "low risk".

High PEs are usually associated with good companies and certainly the market tends to go overboard in the multiples applied to the earnings of the Ryanairs of this world.However companies with low PEs are usually lowly rated for very good reasons.

Again Brendan I say your analysis is far too simplistic .


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## Brendan Burgess (20 Feb 2002)

*Re: Barlo, Unidare etc.*

I have transferred the gross roll up discussion to a new thread.

Does anyone think that the American stockmarket was overvalued at 32 times earnings?

Does anyone think that the Japanese stockmarket was overvalued at 80 times earnings?

My thinking has evolved away from the "too simplistic" and now everyone seems to be jumping back again to the position that 32 times earnings was justified.

I still believe that the markets are very efficient. But occasionally gross overvaluations occur e.g. tech stocks and Japan and probably the American market. 

I am not saying that you should buy low p/e stocks, but I think it is reasonable to say that high p/e stocks are riskier than, let's say moderate p/e stocks.

Brendan


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## Dynamo (20 Feb 2002)

*P/E Ratios*

Hi Brendan,

I have to agree with the other posters - you're getting into very dangerous territory here.

<!--EZCODE BOLD START-->* All other things being equal*<!--EZCODE BOLD END--> you should favour a lower p/e over a higher one - ie for two companies with equal earnings quality, equal growth prospects, of equal size, equal geographic range, equal risk, etc, then you should buy whichever is trading at the lower p/e. The problem is that it is very rare for all other things to be equal when comparing two shares, or two markets.

Step back from the apparently seductive mathematics for a second. The p/e ratio is really little more than the mathematical result of what you have elsewhere described as the actions of purchasers in a second-hand market (for shares). As such, the p/e ratio is probably a useful measure of telling you whether market are in high or low ground. But high (or low) p/es may be justified by particular circumstances and may persist for some time. Or they may prove to be completely unjustified, as they were in the case of the Nasdaq and Japan which you cite. A smart investor should have stayed away from those markets, and many smart ones did ... though probably not quite as many as claim to have done !

P/es are in the public domain along with a raft of other statistical data. You believe in market efficiency and the inability to time markets, as broadly do I. If your pre-disposition is to buy-and-hold, I think that all p/es can therefore give you are (1) the broad valuation level of the market, (2) a comparison of investors perception of one issue over another, and (3) perhaps the occasional alarm-bell like the Nasdaq or Japan.

Other posters have quoted compelling examples that prove that low p/es do not mean less risk, but precisely the opposite - government vs junk bonds, Barlo/Unidare etc. I would add that you can buy emerging markets at lower p/es than Ireland - less than 10 times earnings last I looked. Is Argentina or Indonesia a less risky investment proposition than Ireland ?

Turning finally to the Irish market, I think you can suggest lots of reasons why it should trade at something of a discount. All the companies are (relatively) small and (relatively) concentrated. Even several of the bigger ones have the vast majority of their economic exposure in Ireland. And most of all, investors know that the supply/demand position for the foreseeable future is less than favourable, because of the expectation that the large institutional owners will be sellers at a sensible price. As with most things, there's an equilibrium here - if the market languishes then it will offer good value and there will be buyers. But for the moment the desired selling by the big institutions is a medium-term overhang which I think will continue to act as something of a drag on the market.


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## Brendan Burgess (20 Feb 2002)

*Re: P/E Ratios*

My earlier contributions have been misunderstood.

It seems to me that shares or markets with very high p/e ratios are risky. At its extreme, a ratio of 80 does make a lot of assumptions. If anything goes wrong, that share has a long way to fall.

I have never said that shares with very low p/e ratios are low risk. I have only referred to high risk shares.

I am talking about shares here, so the references to bonds are not relevant.

What I am trying to establish is if there is some way of screening out shares or markets which are more risky than others. Maybe there should be a set of factors;

Shares with very high p/e ratios
Shares with very low p/e ratios
Companies with capitalizaion under €x.
Companies which are not profitable
Companies with a record of dodgy or complex accounting
New technology companies (to include biotech)
Markets which are emerging or in politically unstable areas
Single product companies

I am sure that I am not reinventing the wheel here. Maybe some proper statistical research has been done on this area.

Brendan


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## The Jesuit (21 Feb 2002)

*Perception Risk*

The <!--EZCODE ITALIC START-->_ Boss (can I call you God?)_<!--EZCODE ITALIC END--> argues that when it comes to P/Es Bonds is different from Equities and I think He is right.

US Gov Bonds are on a "P/E" of 20 because they are <!--EZCODE BOLD START-->* perceived*<!--EZCODE BOLD END--> to be of low risk.  Some Junk Bonds are on a "P/E" of 5 because they are perceived to be risky.  By and large those <!--EZCODE BOLD START-->* perceptions*<!--EZCODE BOLD END--> are true.  Certainly you can't get much safer than US sovereign debt.

Now equities are on a high P/E ratio because their earnings are <!--EZCODE BOLD START-->* perceived*<!--EZCODE BOLD END--> to be high quality, full of potential growth.  A low P/E ratio means the market <!--EZCODE BOLD START-->* perceives*<!--EZCODE BOLD END--> that the earnings are low quality, lacking growth.

The difference now is that the <!--EZCODE BOLD START-->* perception*<!--EZCODE BOLD END--> might be wrong.  There is <!--EZCODE BOLD START-->* Perception Risk*<!--EZCODE BOLD END-->.  Clearly that risk is much higher the greater the perception i.e. the gretaer the P/E.

I suggest an eleventh commandment:
<!--EZCODE ITALIC START-->_ "Thou shalt not invest in equities with a P/E 50% higher than the reciprocal of the yield on sovereign debt"_<!--EZCODE ITALIC END-->
or, for the junior cathetism:
<!--EZCODE ITALIC START-->_ "Don't buy shares which are more than half as dear again as bonds."_<!--EZCODE ITALIC END-->


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