Stock Indicators: the essentials in brief
- Higher market prices do not mean that stocks are automatically too expensive.
- Key indicators such as the price-earnings ratio (P/E ratio) provide clues as to how individual stocks or entire markets are valued.
- The optimal times for entry and exit cannot be seen from the stock valuation.
- But it is an indicator of future returns. If stocks were low valued, the returns in the following years were often above average.
- Extreme market valuations have been followed by high share price losses in the past.
- We recommend a look at the Shiller Index.
Prices are only meaningful in relation
Basically, reading of an index does not indicate whether a stock market is currently high or low. Only the ratio of share prices to other sizes provides information on the valuation. With such a perspective, people also get orientation in everyday life when it comes to money.
An employee, for example, whose salary is 2,000 dollars a month, cannot deduce from the total salary whether he earns a lot or little. This only becomes apparent when he compares this sum with the salary of colleagues and their work. It could also use living expenses such as the average rent for an 80 square meter apartment. If the amount were 1,200 dollars, the salary would be low since 60 percent would have to be spent on the rent. On the other hand, if such an apartment only costs 400 dollars a month, the salary would be – relatively – high.
Best of the best stock indicators: The Price-Earnings ratio
The most noted indicator is the price-earnings ratio (P/E). It sets the price of a share in relation to the annual profit per share of the respective company. The profit that a group generates is the central parameter for investors. The higher the earnings, the more valuable a company is. The P/E shows the extent to which profitability is reflected in the share price. It is a multiple of the profit that investors have to pay for a share. A high P/E tends to suggest that a stock is expensive, a low one is an indication of a favorable valuation. It is really the best stock market indicator ever!
An example: A share costs 60 dollars. The profit is 4 dollars per share per year. This leads to a P/E ratio of 15 (share price divided by profit). However, whether this is high or low can only be seen if you compare the current value with the long-term average of the share. For example, if the average was 10, investors view the stock as expensive because it is listed 50 percent above its long-term valuation. The P/E ratio is not only calculated for individual stocks, but also for stock indices that represent entire markets, such as the US.
The P/E ratio increases when prices rise faster than profits. Conversely, it will decrease if earnings grow faster than prices.
Stock Market Indicators: Past and future profits
There are several ways to calculate the P/E ratio. It can be calculated based on past or future profit. Both variants have disadvantages. If the past profit is used, the P/E shows how a share was valued.
An investor typically wants to know if the current price of a stock is reasonable. For this, the future annual profit per share must be compared to the price. However, this size is unknown. Bank analysts and research companies therefore estimate profits. The mean of these forecasts is often used for the P/E determination. Financial data websites like newsscarper.com often mark the corresponding value with a small letter e. It stands for the English word “estimated”.
Don’t overestimate future profits
The problem: the estimates are rather inaccurate. Most analysts are too optimistic. That means they overestimate future profits. As a result, the P/E ratio based on profit estimates is usually lower than that based on the most recent known annual profit. Over the course of the year, analysts often adjust their forecasts downwards.
But that is not the only shortcoming of the P/E ratio. In the classic variant, it is calculated on an annual basis. This leads to cyclical distortions: stocks tend to be valued cheaply on the upswing when earnings are high, and expensive on the downswing when earnings fall.
The Shiller Index
The so-called Shiller P/E ratio, also known as the Cape Ratio or Shiller-P/E, sent a different signal in 2009: American stocks that dominate the MSCI World Index were then moderately valued. Although this key figure also went up, it was far from being as strong as the classic P/E ratio. The difference results from the different construction of the Shiller P/E, which was developed by economist and Nobel Prize winner Robert Shiller . Instead of the company profits for just one year, Shiller uses the average of the earnings of the past ten years. That smoothes out cyclical swings. Many professional investors are therefore guided by the Shiller P/E ratio, which is a good market indicator especially for long-term investors.
Based on this indicator, many equity markets are not overvalued at the end of June 2015; Germany, for example, with a Shiller P/E ratio of 18.2, is close to the long-term average of 17.8. Russia and Italy, for example, are very cheap compared to corporate profits.
The interest level influences the valuation
In addition to corporate profits and price developments, the interest rate level also influences the valuation of shares. But neither the classic nor the Shiller P/E ratio take this into account. In the past, the classic P/E ratio tended to be higher with low interest rates and lower with high interest rates. One reason for this is likely to be the increasing attractiveness of equities when fixed-income securities such as bonds generate less and less interest. Investors are then apparently willing to pay higher prices for shares. This leads to increasing valuations.
Investors should therefore always keep an eye on the interest rate level when interpreting the P/E ratio. In this light, an assessment that appears high or low at first glance may be put into perspective.
More valuation indicators
The Buffett indicator
The dividend yield
The dividend is the part of the profit that a company distributes to the shareholders. If you divide the dividend by the share price and multiply the result by 100, you get the dividend yield in percent. A high dividend yield on the stock exchange is a sign that a stock is undervalued. However, as with the P/E ratio, this key figure also has a data problem. Because the dividend that a company will pay is not known. Like future profit, it must be estimated. This means that the dividend yield is also subject to uncertainty. However, dividend payouts tend not to fluctuate as much as corporate earnings. A high dividend yield in itself is not an indication of a lucrative business. Because even if the price of a share has fallen, the dividend yield increases if nothing changes in the estimated amount of the distribution at first. However, there are often good reasons for discounts, such as poorer earnings prospects. Then it is questionable whether the dividend can be paid in the expected amount.
Conclusion: It is never too late to start!
Anyone who invests in shares for 10-15 years should not need the capital invested during this period. For long-term investors, the Shiller P/E provides good guidance, as the historical data show. With high valuations, yields tended to be lower in the following decade – and vice versa. Exceptions prove the rule.
If you are looking at very low valued countries such as Russia, Italy and France, you should be aware that a low shiller P / E fundamentally signals a good start time, but is no guarantee of long-term high profits. The valuations and the courses can drop even further. The Russian economy is groaning under the sanctions of the West due to the Ukraine crisis, in France and Italy the economy is crippling. Investors who want to invest there definitely need staying power.