FAIRBAIRN CAPITAL INVESTMENT INTELLIGENCE Investment 101 June 2010 Price-earnings multiples and future returns A quick introduction to price-earnings multiples Global equity markets experienced a significant rally from the lows in March 2009. This resulted in a sharp increase in the price-earnings (PE) multiple of several equity indices including the JSE All Share index. The historical PE multiple is one of the most commonly used long-term valuation measures. Historical PE multiples are calculated by dividing the current share price by the last 12 months’ earnings. In comparison, forward PE multiples are calculated by dividing the current price by the expected earnings for the next 12 months. This article explores the relationship between the historical PE multiple and the subsequent 5-year capital return (per year) achieved on the JSE All Share. The historical PE multiple is roughly a measure of how much is paid for each R1 of earnings generated each year by the companies included in the All Share index. As such, a high PE indicates that each R1 of earnings costs a lot (or is expensive) while a low PE indicates that each R1 of earnings is relatively cheap. At the end of May, the historical PE multiple was 16.37, indicating that shares were trading at over 16 times earnings – an indication that the market was possibly expensive. If future earnings grow strongly (which is the current consensus view) and share prices remain more or less constant, the PE multiple will decline. The PE multiple will also decline if share prices fall but earnings remain stable. If earnings and share prices increase at a similar rate, the PE multiple would remain constant. The JSE All Share Index and the Historical Price-Earnings Multiple The graph below plots the PE multiple for the JSE All Share index from 1960 to the end of May 2010. Source: I-Net, FCII The average PE multiple over the past 50 years was 11.79 (the thick black line on the graph above), and the current PE multiple for the JSE All Share index is clearly above that long term average. Over the 50 year period, the PE multiple reached a maximum of 25.64 and a minimum 4.10. Taking this, and the average, into account, we divided the historical data into five ranges, explained below: Range 1. High PE • A PE multiple greater than 15.50 is considered to be high, and PE multiples in this range typically signals that the equity market is expensive. • Had you invested at market valuations in this range over the previous 50 years, the average subsequent 5-year return would have been 5.90% (the lowest average among the five ranges). The best possible return would have been 13.59% and the worst would have been -2.86%. Range 2. Moderately High PE • A PE multiple that falls between 12.79 and 15.50 is considered to be moderately high, typically signalling a moderately expensive market. • Over the past 50 years, this range of PE multiples would have yielded an average 5-year return of 10.72%, with a maximum return of 21.60% and a minimum return of -2.91%. • Approximately 4% of the subsequent 5-year returns were negative following a PE greater than 12.79. Range 3. Average PE • When the PE multiple falls between 10.79 and 12.79 – close to the long-term average - the JSE All Share is considered to be fairly priced (not too cheap, not too expensive). • This range had an average return of 11.05%, a maximum return of 25.92% and a minimum return of -3.61%. Range 4. Moderately Low PE • A PE multiple between 8.00 and 10.79 is considered to be moderately low, typically signalling a moderately cheap market • Investments made during periods when the PE multiple was in this range would have yielded an average 5-year return of 15.52%, a maximum return of 32.56% and a minimum return of 3.29%. Range 5. Low PE • A PE multiple less than 8.00 is considered low, typically signalling a cheap market. • This range had an average return of 23.20% (the highest average among the 5 ranges), a maximum of 38.83% and a minimum of 10.75% The findings are summarized in the table overleaf. Please note that while care has been taken to ensure that the information provided in this article is correct, it represents an overview of the topic under discussion and as such does not constitute advice. We suggest that you contact your professional adviser before taking any decisions based on the information herein. Fairbairn Capital is an elite service offering brought to you by Old Mutual Investment Services (Pty) Ltd and Old Mutual Life Assurance Company (South Africa), Licensed Financial Services Providers. Annualised 5 -Year Returns Subsequent 5-year Return Maximum Return Minimum Return per annum High PE 5.90% 13.59% -2.86% (PE ≥ 15.50) Moderately High PE 10.72% 21.60% -2.91% (15.50 > PE > 12.79) Average PE 11.05% 25.92% -3.61% ( 12.79 ≥ PE ≥ 10.79) Moderately Low PE 15.52% 32.56% 3.29% (10.79 > PE > 8.00) Low PE 23.20% 38.83% 10.75% (PE < 8.00) Source: I-Net, FCII The graph below shows the PE multiple plotted against the subsequent 5-year returns. It is apparent from the graph that there is an inverse relationship between the historical price-earnings multiple and the subsequent 5-year returns on the JSE All Share. That is to say that the lower the historical PE multiple, the higher the subsequent 5-year returns. Conversely, the higher the PE multiple, historically, the lower the subsequent 5-year returns. Source: I-Net, FCII As can be seen from the graph, based on the historical PE, when the market appeared fairly “cheap” (highlighted in the green section on the graph) returns were generally above average. In contrast, when the market appeared relatively “expensive” (highlighted in the red section on the graph) returns were generally below average. Numerous fund managers are cautioning that valuations of South African shares are stretched. No one knows what lies ahead, however, based on historical evidence, investing at higher price earning multiples resulted in below average returns. Put differently, the odds of getting a low (or even negative) return increases as the price-earnings multiples increase. Historically, the best time to invest has been when price earning multiples were low. The price-earnings multiple for different sectors on the JSE or individual shares might of course be different. With this in mind, we continue to propose a measured exposure to equities. Please note that while care has been taken to ensure that the information provided in this article is correct, it represents an overview of the topic under discussion and as such does not constitute advice. We suggest that you contact your professional adviser before taking any decisions based on the information herein. Fairbairn Capital is an elite service offering brought to you by Old Mutual Investment Services (Pty) Ltd and Old Mutual Life Assurance Company (South Africa), Licensed Financial Services Providers.