Feb 10

Don’t forget the E in PE

Source: RBA

The above left chart, Forward PE Ratio, shows that the Australian sharemarket is potentially relatively cheap at the moment. The forward PE ratio, which is the ‘current price’ of the Australian sharemarket divided by forward estimates of earnings, has only been lower during the GFC and the 1990-91 recession ‘we had to have’. So on that basis alone, it appears that Australian shares may be worth buying.

However, the concerning part of that equation comes from the chart on the right, where the black line labelled 11/12 is trending sharply down. So whilst we may believe the “price” is low based on the PE ratio, the reality may be that it is “forecast earnings” are high. As forecast earnings decrease, the Forward PE Ratio will increase independent of price, and eventually may not look so attractive any more. Over the last 12 months analysts have consistenty decreased their forecast earnings for the Australian sharemarket and the current trend does look a tad worrisome.

So before you consider that a sharemarket is cheap (or hear it from a fund manager!) because the Forward PE Ratio is low, please consider whether forecast earnings are too high and likely to decrease….which is easier said than done…as the PE Ratio is a dangerous measure to be used alone.

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  1. AFundie

    In defence of my employers (not something I do on a regular basis) and other fund managers I actually don’t think you’ll find many managers here who wouldn’t concede earnings expectations are still too high and are still being revised down. So yes the E is under pressure and the E is still about 10-20% below the 2007 peak. NPAT is above these levels but there was a huge amount of dilutionary capital raisings in 2008-9 which affected EPS.
    But it is hard to deny the P has been under even more pressure than E, how far is the P below the 2007 peak? 🙂
    Even if the current expectations for 8-9% EPS growth this year and 13% next fall by 5% the market would still look cheap by historical standards – yes P/Es were lower in the 70s but where was inflation then?
    Of course if Europe implodes this year and we have a second global recession then the market could quickly look expensive.

  2. michael

    Great comment…thank you. Anyway…It was mentioned at a conference I was at yesterday that only the Great depression and the inflationary 1970s are comparable to the global economic situation we have today…John Quiggin said this I believe. So, I don’t quite believe that the PE ratio being compared to historical averages(like every fund manager does) is an apples and apples comparison…there needs to be a little more context for the PE to make true sense.

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