Explain why investors use the P/E ratio as a valuation measure.
going through the process of how financial professionals estimate the value of a company. Ultimately, all of our valuation methods will rely on finding the present value of future cash flows, which is the standard method of valuing anything in finance, whether it be an individual security (such as a bond) or an entire company. It can also useful to apply some of the same valuation measures to the stock market as a whole, although they should be used with caution, as you will learn from this assignment.
- Price/Earnings or P/E ratio
- a) Explain why investors use the P/E ratio as a valuation measure. 2 marks
The investors use the P/E because investors want to buy financially sound companies that offer cheap shares. The P/E ratio makes easier for investors to compare same companies within the same industry regardless of their various stock prices. It is also a quicker way to value a company using earnings. When there’s fluctuation: high or low P/E is found, we can quickly access what kind of stock the company is dealing with.
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- b) Explain the difference between trailing 12-month P/E and forward P/E. Compare the two measures of firm value, explaining the benefits and drawbacks of each one. 3 marks
The key difference between forward P/E and trailing 12-month P/E ratio is that the forward measurement is based on projected future 12 months earnings, while the trailing 12-month P/E is based on the recent or past 12 months actual earnings. It benefits to compare the two measures of firm value to see if there’s any raising or declining trends in the forward verses trailing P/E figures. The drawback of forward P/E ratio is based on the future estimates. For example, some companies could underestimate or over estimates their earnings, where as the trailing P/E ratios is based on the past 12-month performance and it is not necessarily that company do well in the current period.
- c) Graph the P/E ratio for the S&P 500 for the last 100 years (annual data is fine). Comment on the current level of the P/E ratio compared to the past 100 years, especially compared to the 2000 tech stock bubble and the 2007 stock bubble prior to the financial crisis. 3 marks
The change in P/E ratio determine the value of the stock in the market. The investors buy more stock when the P/E ratio is low and sell when the P/E ratio is high because buying at the high level increase the risk of negative return. Buying at low point increase the level of higher return. For example, the chart below shows that investors were fortunate to buy more stock in the years (1918-1921, 1924,1942,1943,19,48, 1949, etc) when the market P/E ratio was below or at 10 to receive excellent returns in the future. In 2007 the inflation rate was low and
- Shiller CAPE ratio
Robert Shiller of Yale University argues that a better measure is the cyclically-adjusted P/E ratio, or CAPE ratio, which is also known as the Shiller P/E.
- a) Explain why this measure should be superior to a trailing 12-month P/E ratio. 2 marks
- b) Graph the CAPE ratio for the S&P 500 for the last 100 years. Comment on the current level of the CAPE ratio compared to the past 100 years, and again compared to 2000 and 2007. 3 marks
- Market Cap/GDP
Legendary investor Warren Buffett says that his favourite measure of stock market valuation is overall market capitalization/GDP, where the numerator is the market capitalization of the Wilshire 5000 index of all U.S. stocks. Using data available from the FRED database from the Federal Reserve Bank of St. Louis (fred.stlouisfed.org), graph the market cap/GDP ratio from 1970 to the present. Comment on the current level of this ratio compared to the historical data, especially in 2000 and 2007. 3 marks
- Interest rates
Read the October 2017 Market Comment from John Hussman, PhD, titled “Why Market Valuations are not Justified by Low Interest Rates” found at the following link:
- a) Explain how the dividend-growth model estimates the price of a stock (refer to your textbook). What happens to the price when the interest rate is higher or lower? 3 marks
- b) Explain Hussman’s argument that if interest rates are low because growth rates are low, then stock prices should not be higher. 3 marks
- c) Explain Hussman’s argument that comparing prices to earnings (i.e. using a P/E ratio) is not useful for estimating future investment returns. 3 marks
- d) Explain why U.S. real GDP growth is expected to be low over the next few years. 3 marks
- e) What does Hussman conclude about the current level of stock market valuations? 3 marks
- The equity allocation approach to future investment returns
For a different perspective on stock market valuation, read the following posts from Philosophical Economics:
- a) According to the first post, what factors are responsible for the total investment returns from buying a stock? 3 marks
- b) Explain the relationship between equity asset supply and future investment returns. 3 marks
- c) According to the second post, why is the valuation approach to estimating future investment returns flawed? 3 marks
- Putting it all together
Based on your readings from this assignment, evaluate the different approaches to stock market valuation. What do you conclude? 10 marks