Australia’s long-term trend for the average Price-Earnings (P/E) ratio for stocks is said to be around 15. With the recent rout in the global stock markets, some market commentators have been saying that right now, with Australia’s average P/E ratio approaching the long-term average, Australian stocks is not ‘expensive’ in general. The implication is that if the stock market continues falling, stocks will be approaching the ‘cheap’ territory and therefore, become ‘bargains’ in general.
We would like to warn you against such simplistic reasoning because it can be deadly to your wealth.
First, you have to understand the underlying assumption behind using the P/E ratio as a means to ascertain the relative value of a stock. The valuation method using P/E ratio assumes that earnings growth of the business behind the stock is consistently growing indefinitely. It assumes that interest rates are constant.
To illustrate this point, we will use an example. Let’s say that Company Steady-Secure’s business is absolutely risk-free and its earnings are growing at an annual rate of 1.35% forever and ever. Based on the risk-free Treasury bond yield of 8% (that is, the risk-free interest rate is 8%), then the future earnings of Company Steady-Secure is worth around $15 today for every dollar of earnings in one year’s time. Let’s change the risk-free interest rate to 10%. How much will Company Steady-Secure’s future earnings be worth today? The answer is $11.56. Now, let’s change the earnings growth to be 0.5% instead. This time, the future earnings will be worth $13.33. Finally, let’s change the earnings growth to be -10% (i.e. shrinking earnings over the years, forever and ever). Guess how much the future earnings is worth today? It’s $5.56!
If you do not understand how we work this out, do not worry about it. The key point to understand is that in an environment of:
- Rising interest rates – P/E ratio will fall because the intrinsic value of a business’s future earnings will fall (i.e. price will fall to reflect the falling intrinsic value).
- Falling earnings growth (even negative growth) – P/E ratio will rise if the price (the numerator) is to remain constant. If earnings growth is falling (including shrinking earnings), then the intrinsic value of a business’s future earnings will fall. This means it will be irrational for the stock price to even remain constant.
Now, what does this means for us today? Back in February last year, in Where are we in the business cycle?, we commented that
Thus, we believe that Australia (and the US as well) is at the top of the business cycle.
Indeed, right now, the US is past the peak of the business cycle (forget about the mainstream obsession of trying to be extremely precise on defining what a recession technically is- see Example of precisely inaccurate information). We can expect the US companies’ earnings growth to fall and even shrivel over the years.
For Australia, interest rates are in a rising trend, which is a symptom consistent with the peak of the business cycle. Back in March last year, in Pitfalls for businesses in ?accelerating? economy, we commented that
As we said before in Have we escaped from the dangers of inflation? and with the Westpac survey confirming our view, Australia is very much likely to be hit with more price inflation in the days to come. Thus, the implication is that there will be more interest rates rise to follow.
Now, with the benefit of hindsight, we can see how accurate our prescience for the following months were. Today, we can see that the forces of price inflation is pressing the Australian economy, with further warning from the central bank that we should be expecting more interest rate rises in the months to come. As this news article says today,
Home owners should be prepared for another official interest rate rise after the governor of the Reserve Bank made it clear controlling inflation was his greatest concern, not the global financial crisis.
Our long time readers should not be surprised at this threat to the Australian economy because we had been warning about it for a very long time already. It was amazing that sometime in the vicinity of September last year, a certain politician from the Treasury Department was confidently predicting (in front of the news camera) that the next CPI report would show abating price inflationary pressures. Well, history showed that he was completely wrong. Indeed, it is very strange that this politician’s political party is still perceived to be the better economic manager than the current ruling party of the Australian government, as if governments of today can control the economy the same way cars can be controlled.
Therefore, our dear readers, do you see something very obvious? Australia is now in a trend of rising interest rates. Falling earnings growth should follow soon. Therefore, a falling average P/E ratio is consistent with all these symptoms of a turning business cycle. As we said before in What to avoid at the peak of the business cycle?,
One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle.
In short, at the turning point of the business cycle, a falling average P/E ratio does not imply that stocks in general are cheap. Yes, with careful and judicious stock picking skills, you may be able to find really cheap stocks. But do not let falling average P/E ratio fool you.
