Price-to-earnings ratio

Buy low, sell high. It is a simple formula for investment success, but with so many ways to measure a market, and with conflicting results, following it can be difficult.

To help, we today highlight three closely watched valuation measures, and others that are growing in popularity.

We start with the most widely used calculation. The p/e ratio compares a company’s value with its profits. To work it out you take the share price and divide it by the annual earnings per share figure. Another way to look at it is that if the company is valued at £10bn and makes £1bn in annual profits, its p/e ratio is 10.

The lower the figure the better. With stock markets, you would compare the p/e with other countries, or with its own long-term average. With shares, you compare it with rivals. For instance, if the average p/e for all bank stocks is 15 and your bank stock is at 10, you may have a bargain.

Cape ratio

It has a daunting title – “cyclically adjusted price to earnings” – but the Cape is growing in popularity. Essentially, it is the p/e ratio with a twist. Instead of using earnings over 12 months, this valuation measure takes the average earnings figure over the previous 10 years.

In doing so the Cape ratio strips out short-term anomalies. One of the main criticisms aimed at the p/e, the more basic measure, is that a market could be deemed “cheap” because earnings have just reached their peak in the economic cycle and are about to fall. By taking the average for 10 years, the ups and downs of the cycle are evened out. It was first dreamt up a generation ago by investment gurus Benjamin Graham and David Dodd and refined by US academic Robert Shiller in the Nineties.

This measure, though, does have critics. Richard Troue of Hargreaves Lansdown, the fund shop, said: “It can be slow to acknowledge genuine stock market shifts. For instance, Japan’s collapse into deflation and stagnation took years to be fully acknowledged.”

Price-to-book ratio

Rather than focusing on earnings the price-to-book ratio examines how a company’s market value compares with the value of its underlying assets – the value of all the buildings, machinery and intangible assets if sold today.

To calculate the price-to-book ratio for the whole index you need the value for each share. A low score signals that a stock market or share is undervalued. A figure of less than one is viewed as a bargain, as it means investors are buying at a discount to the value of a firm’s assets. But bear in mind it could be cheap for a reason.

According to Miles Standish, managing director of Fisher Investments UK, this measure is more useful because some firms manipulate their earnings figures, which can distort the average valuation for the entire stock market.

“The book value cannot be manipulated, but there are plenty of ways for earnings figures to be fudged or glossed over,” said Mr Standish.

Best of the rest

Perhaps the most basic way to gauge the value of the stock market is to look at the dividend yield.

David Fuller's view

Here is The Telegraph article.

It is well worth reading the rest of this article before clicking on the Expensive to Cheap graphic.  I found it fascinating, although Canada was a glaring omission. 

I was not surprised to see China / Hong Kong or Japan in the Cheap list but India did surprise me.  If they are right, then it will do even better than I expect over the next four years or more.

I suggest you combine this valuation work with technical performance studies.  For instance, you probably do not want to start investing in the more expensive markets, but they are in fashion so I would stay with them until their relative outperformance begins to wane.  Similarly, cheap markets that are not performing are out of favour, so if you do not wish to be too early, even if compensated by good yields, go lightly until the relative performance kicks in. 

Also, these studies are about countries rather than sectors.  That may be OK for you, if you are going to invest in a fund.  However, if you prefer to cherry pick among individual shares, you can start by studying sectors and individual share performances in the Chart Library.  You can also see what the funds are holding in their top-10, and then look at charts to select the inform patterns. 

I hope The Telegraph will make this a regular feature and eventually add another version covering more emerging and also frontier markets.