No valuation measure will help you time the market. But the cyclically adjusted price/earnings ratio (Cape) has proved a good guide to long-term returns in equity markets around the world, says Jonathan Compton.
If you own a bicycle, you need to acquire some simple technical knowledge, such as how to pump up or repair the tyres, adjust the height of the seat or handlebars, tighten the brakes or put the chain back on. Most cyclists can perform these undemanding tasks with their eyes closed. When it comes to making money from stockmarkets, however, most investors – even those paid to look after other people’s money – tend to react nervously to rigorous analysis of markets, sectors or stocks. Often unaware of how it actually works and afraid to appear foolish, investors resort either to bluffing or a general dismissal of analytical tools designed to establish whether equities or markets are good value at the current price – even though some of these measures have an impressive record in helping to forecast market returns or mitigate losses.
One well known and frequently used measurement, for instance, is the price-to-book ratio. This is calculated by adding up a company’s total assets and then subtracting intangible assets such as patents and debts and other liabilities. This amount, divided by the number of shares, is the book value per share, which in turn is divided into the share price.
A price-to-book value below one means a company is trading below the value of its assets (and is therefore a bargain), while above that number it is trading at a premium. As a rough test this can be useful, but it has many flaws. For a company such as Amazon, which over the last five years has never traded below 12 times book (it is now on 19.8 times), using book value per share as a guide to buy or sell would have been an enormous mistake because the share price has risen five-fold. The same applies to many other valuation tools from Tobin’s Q (a refinement of the simple book value gauge) to Altman-Z scores (a useful indicator of financial distress). No single valuation tool provides a wholly accurate signal of when to buy or sell.
A reliable indicator of long-term returns
Yet there is one system which, correctly used, has proved a surprisingly reliable indicator of likely long-term future market returns; it also serves as a switching guide between different national markets and even between sectors and stocks within a single market. This is Cape, an acronym for the cyclically adjusted price/earnings ratio. Its origins lie with the doyens of value investors, the pioneering Benjamin Graham and David Dodd, who were trying to bring a more rational approach to calculating a firm’s intrinsic value and thus whether its share price was cheap or expensive.
They published their findings in two books, Security Analysis and The Intelligent Investor, in 1934 and 1949 respectively. Dry as dust though both are, they attracted many disciples (of which the most famous is Warren Buffett) who successfully ran with their ideas. They believed that using a company’s price/earnings multiple (or p/e) with a single year’s earnings to estimate value was too volatile a measure to indicate a company’s true earning power and future capacity to pay dividends (investors paid far more attention to income then than today).
So they started to look at long-term averages for earnings, often five to ten years, and adjust these for inflation. Smoothing out earnings over a longer period reduced the inherent volatility and inaccuracy of looking at a single year’s earnings and, crucially, allowed them to assess how well a company performed over a full business cycle. Like many good ideas, its utility only became obvious with hindsight.
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