| Company | Forecast PE |
| ASOS [ASC] | 70 |
| Dominos Pizza [DOM] | 33 |
| Aggreko [AGK] | 19 |
| GlaxoSmithKline [GSK] | 9 |
| Xstrata [XTA] | 9 |
The forecast PE shows that online clothes retailer ASOS is very expensive now after a period when it defied the recession with a share price rise of about 1500% over five years. After share price growth at this rate I suppose you would expect it to be expensive; and the PE shows it to be over five times more expensive than the average share. It may still be a quality company but without doubt you are now paying a high price for that quality.
Maybe more people like pizzas than I think, but the current PE rating on Dominos looks very expensive to me.
Aggreko is a global supplier of mobile power and has supplied events such as the football World Cup and the Olympics. It has been one of the stars of the FTSE in recent times with its PE increasing from nine three years ago to 20 at the time of writing. In other words, it has moved from a cheap share to a relatively expensive one. It is a company that I still like, but its present rating is a little high, which makes me think the stock price will, at least, pause for breath before resuming its growth.
The PE on Glaxo appears too low. It has moved from a growth stock to a value one with a PE of less than ten and a dividend of more than 5%. Have the heydays of the big pharmaceutical come to an end? Obviously, judging by its PE a lot of investors think so. It’s true that fewer new drugs will come to the market in the future; and at the same time more of the old ones will lose their patent protection and face competition from cheaper generic versions. In addition, potential litigation costs are rising. Obviously, different views abound – after all, that’s what makes a market in the first place. But I believe that this share is now too cheap. The present PE ratio would indicate to me that this company would justify inclusion in a portfolio as a lower-risk, high-dividend player. Although the growth potential is less than many shares, so is the downside. Successful stock investment is about investing in shares where the risk-reward ratio is skewed in your favour.
Finally, Xstrata [XTA] looks cheap with a PE of nine. Will growth in China and emerging markets continue to support the price of commodities? Obviously, this rating suggests that many think it will falter. However, this PE looks too cheap. In fact, many of the miners do. BHP Billiton [BLT] has a similar rating of ten which may suggest much of the mining sector is undervalued at the present time.
Obviously, the above views are purely personal and they have a limited shelf life. However, hopefully this quick overview demonstrates that when it comes to assessing individual shares PE ratios have a part to play.
In isolation they do not provide the whole picture, but they do provide a few pieces of the jigsaw. They provide a background against which the share and its current price can be assessed. They tell you whether the stock is cheap or expensive and once this is established you are able to make other value judgements. Used in this way, they can simply help you make more informed investment decisions.
Using the PE to compare companies in different sectors
Some people feel when making stock comparisons the PE is only useful when you compare stocks within the same sector. Although I understand the logic here, I don’t agree with it. Some sectors offer the promise of growth more than others (e.g. bio-techs) and this will be reflected overall in higher PEs. However, this simply means that the sector is more expensive. Investing within it inevitably means there is more downside risk as there is greater scope for disappointment. Although you should take into account the average ratings in each sector when making investment decisions, I believe cross sector comparisons using PEs are still valid and act as a useful reminder of the real price we are paying for a share.
Market comparisons
I think the greatest strength of the PE is as a measure of the overall market. For example, the UK market has a long-term average PE of 15, while the world market has a long-term average PE of 16. These can be used as a guide to current value, and help determine the amount of money that should be invested in the different asset classes. When it comes to geographical diversification it can also inform choice. My view is simple: the lower the PE, the cheaper the market and the greater the value on offer.
The following table lists the trailing and forward PEs of the World and UK markets as at end 2010:
| UK | World | |
| PE (2010) | 12.0 | 14.6 |
| PE (2011) | 10.6 | 12.7 |
| Long-term average | 15.0 | 16 |
Source: Factset MSCI Barclays wealth strategy
As these figures for the equity markets are below the long-term averages it would indicate to me that equities at present offer good value and therefore it is an asset class in which the investor should be overweight. This position is also supported by the following chart:
Figure 3.1: PE of the MSCI world Index
The chart shows that using the 1 year forward PEs as your guide, the world markets have been significantly undervalued throughout 2009 and 2010 as the market PEs have been significantly below the long-term average (shown on the chart at just above 16).
I find the PE a better guide to value in the general markets than it is for individual shares.
It also helps to inform the timing of investment. There is plenty of historical evidence that shows the market PE is inversely correlated with subsequent stock market returns. In plain English this means that purchases made when market PEs have been below the long-term average (as they are now) have made more money in subsequent years than purchases made in years when the PE was relatively high.
The Rule of 20
This is a good place to mention what is known as The Rule of 20. This is an equity market valuation method that refines the use of the PE as a guide to value in the overall market. The rule works on the premise that fair value in the equity markets exists when the aggregate of the market PE and the current rate of inflation is 20. If the sum comes to less than 20, the rule suggests the market will rise. Over 20, and the rule indicates the market will fall. The more extreme the figure, either on the low or high side, the more certain the indication. In essence, the rule is a simplified dynamic asset allocation technique.
It’s just a rule of thumb, but one which certainly passes my “3 Box Test” (referred to in the preface to this book). Over the years it has proved a very useful guideline that has helped me to decide whether to increase or decrease the current level of my equity investment.
Conclusion
In summary, I believe the PE is a much better guide to value of the overall market than it is for individual shares. In fact, I would regard the one year forecast PE to be by far the best guide of value when it comes to general market levels.
With