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SINGAPORE (Dec 28): Global investors should beware the temptation to simply compare a valuation metric for one region with that of another, according to global investment manager Schroders.
In a Thursday media release, Duncan Lamont, Head of Research and Analytics, discusses the five ways to measure stock market value, namely: forward price-to-equity (P/E), trailing P/E, cyclically adjusted P/E (CAPE), price-to-book (P/B) and dividend yield.
An obvious drawback of using forward P/E as a valuation measure, says Lamont, is that no one knows what companies will earn in future, and that analysts have a tendency of overestimating and making shares seem cheaper than they really are.
The same applies to trailing P/E, which takes the past 12 months’ earnings instead and may also give a misleading picture, he adds, especially if earnings have slumped but are expected to rebound – such as in the case of UK equities, which are presently expensive on this measure because of their past commodity price declines and large exposure to commodities.
CAPE or the Shiller P/E, on the other hand, attempts to smooth out short-term fluctuations in earnings by comparing the price with average earnings over the past 10 years.
“When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive,” comments Lamont.
Meanwhile, the P/B method may give rise to significant variations around the world due to differences in accounting standards. The research head also notes that P/B is “largely meaningless” for technology companies or companies in the services sector, as they have little in the way of physical assets.
Lastly, while Lamont acknowledges that using dividend yield has been a useful tool for investors to predict future returns, it has become “unstuck” over recent decades due to the increasing popularity of share buybacks as opposed to paying dividends, which will in turn help to push up a company’s share price.
“This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth,” he observes.
Among the major stock markets, Schroders highlights Japan as the one which could arguably make a case for being attractively valued, given its above-average dividend yield and cheap valuations on a P/E basis. The region’s market also has the added advantage of expanding profit margins, in addition to supportive monetary and fiscal policy.
The US sticks out as the most expensive market on the other end of the spectrum, which is unsurprising to Lamont, who thinks valuations are highly likely to count against the US market in the long term although they are rarely in themselves the reason why markets take a turn for the worse.
He also cautions that prices for emerging markets (EMs) have now shifted to expensive territory on most bases, such that returns may moderate significantly.
While the research head notes valuation metrics for the UK hints at cheapness, he believes it is very expensive on a trailing P/E basis and is “heavily reliant on the oil price recovery holding out, due to oil companies making up such a large chunk of the market”.
In his view, Europe is better placed than valuations would suggest, given that a cyclical recovery is underway with room for profit margins to expand as well as support earnings and stock market returns.
“Differences in accounting standards and the makeup of different stock markets mean that some always trade on more expensive valuations than others,” says Lamont.
“Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future,” he concludes.