The UK stock market appears to be neither very expensive or particularly cheap when analysed through several valuation metrics, while the US can be seen as “reassuringly expensive” and value remains in Japan. 
That’s the view of Duncan Lamont, head of research and analytics at Schroders, who argues that investors need to understand the different ways of valuing equity markets and when it is best to apply each one.
“Valuation is key to making investment decisions,” he said.
“Invest when markets are expensive and future returns are likely to be poor over the medium to long term. Buy when markets are cheap and the odds are stacked much more in your favour.
“But a word of warning – valuations are useless at predicting stock market behaviour over short time frames when fear, greed and other noisy factors tend to dominate.”
Performance of FTSE 100 over 10yrs
Source: FE Analytics
Lamont pointed out that there are many measures that investors can use to ascertain the value of a given stock market but “each tells a different story”.
“They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit,” he added.
He highlighted five different metrics that investors should have on their radars, before explaining what they could be telling us about the major stock markets.
Forward P/E
The forward price-to-earnings multiple or forward P/E is a common valuation measure, where a stock market’s value or price is the divided by the aggregate earnings per share of all the companies over the next 12 months. A low number represents better value.
“An obvious drawback is that no one knows what companies will earn in future,” Lamont said. “Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.”
Trailing P/E
Similar to forward P/E but using the past 12 months’ earnings, this is one of the most common valuation measures. While it removes the need for forecasting, it can give a misleading picture as the past is not guide to the future – especially if earnings have slumped but are expected to rebound.
“For example, UK equities are very expensive on this measure at present, partly because of past commodity price declines and the UK market’s large commodity exposure,” Lamont said.
“However, commodity prices have rebounded amid an expectation of a profit rise this year. The UK therefore looks very expensive on a trailing P/E basis but less so on a forward P/E basis.”
CAPE
The cyclically-adjusted price-to-earnings multiple (CAPE) has become increasingly popular in recent years. Also known as the Shiller P/E in deference to the academic who first popularised it, this metric attempts to overcome the sensitivity that the trailing P/E has to the last 12 months’ earnings by comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation.
“This smooths out short-term fluctuations in earnings,” Lamont added. “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.”
Price-to-book
This multiple compares the price with the net asset value (or ‘book value’) of the stock market. Therefore, a high value means a company is expensive relative to the value of assets expressed in its accounts, possibly because higher growth is expected in future, while a low value suggests the market is valuing it at little more – or even less, if the number is below one – than its accounting value.
“This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation,” Lamont explained.
“However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world.”
Dividend yield
Lamont said dividend yield, or the income paid to investors as a percentage of the price, has been used by many to predict future returns as a low yield has been associated with poorer future returns. But he argued that this might not be the case at the moment.
“While this measure still has some use, it has come unstuck over recent decades. One reason is that ‘share buybacks’ have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price). This trend has been most obvious in the US but has also been seen elsewhere,” he said.
“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.”
Lamont added that investors should be wary of simply comparing a valuation metric for one region with another’s, owing to the fact that accounting standards and the makeup of different stock markets mean there are reasons why some will always appear more expensive than others.
A preferable way is to look at whether a market looks more or less expensive compared with its own historic. This has been done for the major equity markets in the table below, where green is cheap compared with its 10-year average, amber is neutral and red is expensive.
Equity market valuations versus 10-year average (medians)
Source: Schroders
When it comes to the UK, it was trading on a CAPE multiple of 14 times compared with a 10-year average of 20 times, thereby looking “very cheap”, while the trailing and forward P/E are more expensive than their 10-year averages; the market looks more neutrally valued on a price-to-book and dividend yield basis.
“On a longer term basis, the UK overall comes out relatively neutral overall,” Lamont said. “Valuations are unlikely to be the key to performance with Brexit, sterling and commodity prices meriting closer attention.”
For the US, which looks expensive, on CAPE, forward P/E, trailing P/E and price-to-book, it is difficult to see “anything but tough times ahead” over the long term. However, the US also has the strongest economic growth and could benefit from president Donald Trump’s reflationary plans.
“It could be argued that it is a gem in a world of disappointing prospects elsewhere. Reassuringly expensive you might even say. It would take a brave investor to turn their back on the US entirely,” Lamont said.
European equities have started to look expensive after enjoying a strong run. Schroders’ data has them in the red on all five metrics.
Valuations appear to be more attractive in Japan as its price to book of 1.3 times would be “exceptionally cheap” anywhere else in the world. That said, Japanese companies have historically been notoriously inefficient which has led investors to value them at a discount relative to other regions.
Finally, emerging market equities still look attractive even though they have also been on a strong run and are no longer as cheap as they once were. “They are slightly expensive on a trailing P/E basis but are otherwise positioned quite favourably, at least in relative terms,” Lamont concluded.