Price-Earnings Ratio, also called Price-Earnings Multiple is a common metric for valuing the stock market. Just divide the current market price by the annual earnings. The ratio, which has units of years, tells how many years it will take for earnings to payback the current price.
Which Earnings?
The only problem is which earnings to use as the divisor? Some analysts like to use operating earnings, which is the earnings before certain expenses like depreciation and taxes. But leaving out some of the expenses paints too rosy a picture.
Using reported annual earnings, or GAAP earnings, as the divisor is more accurate since it accounts for all expenses.
The Business Cycle: Earnings Fluctuate
The business cycle is well documented. There are times of economic expansion, followed by times of economic contraction, called recessions. Corporate earnings fluctuate widely each year with the business cycle.
During recessions, GDP contracts and the sales of firms fall, while expenses stay relatively constant,. The result is a drop in earnings during recessions of -50 percent or more. During the 2008 recession, corporate earnings fell by closer to -90%.
Permanent Earnings
What investors really care about is the permanent earning power of businesses. One estimate for permanent earnings is to take the simple N-year moving average of earnings. This idea was first suggested by Benjamin Graham back in the 1930’s in his book The Intelligent Asset Allocator. Graham suggested taking an average of earnings over the past 5 or 7 years, to include one complete business cycle. This smooths out the ups and downs, and presents a truer picture of the earning power of firms.
More recently, taking a 10-year average of inflation-adjusted reported earnings was suggested by Robert Shiller in his book Rational Exuberance, published in 2000. The 10-year average of real earnings has come to be known as P/E10, or Cyclically-Adjusted Price-Earnings Ratio (CAPE). For the S&P Composite Index, data for CAPE is available going back to 1871. Here you can find a graph of S&P 500 CAPE
Foreign Stock Market CAPE
But what about CAPE, or P/E10 , for international stock markets. Data for stock markets in foreign countries is not as readily available as for U.S. markets. But one market researcher, Mebane Faber, has managed to gather information about foreign markets.
In this article, Shiller CAPE for the G8, there are graphs of CAPE for the G8 countries. The article is dated 31-Jan-2012.
A more recent article by Mebane Faber, Global Shiller CAPEs, dated 24-May-2012, shows the CAPE for 29 countries. A tip of the hat to Mebane Faber** for publishing this valuable information about international stock markets.
Expected Real Return of Stocks
The inverse of PE Ratio is the Earnings Yield. Now if earnings were constant, or permanent, the earnings yield. E/P, would be similar to a bond coupon rate, and indicative of the rate of return that can be expected. Of course, earnings are uncertain and fluctuate, but that’s why we average real earnings over ten years, E10, rather than single year earnings, E1. E10 is an estimate of permanent earnings.
Table 1 shows the list of 29 countries, along with the value of CAPE as of the end of April 2012.
| Rank | Country | Region | CAPE | E[R] |
|---|---|---|---|---|
| 1 | Italy | Europe | 7.34 | 13.6% |
| 2 | Spain | Europe | 8.33 | 12.0% |
| 3 | Netherlands | Europe | 9.40 | 10.6% |
| 4 | Belgium | Europe | 9.62 | 10.4% |
| 5 | Russia | Emerging Market | 10.24 | 9.8% |
| 6 | France | Europe | 10.98 | 9.1% |
| 7 | Austria | Europe | 11.96 | 8.4% |
| 8 | China | Asia | 12.88 | 7.8% |
| 9 | United Kingdom | Europe | 13.24 | 7.6% |
| 10 | Singapore | Asia | 13.27 | 7.5% |
| 11 | Germany | Europe | 13.70 | 7.3% |
| 12 | Australia | Europe | 14.01 | 7.1% |
| 13 | Turkey | Emerging Market | 14.65 | 6.8% |
| 14 | Switzerland | Europe | 14.67 | 6.8% |
| 15 | Japan | Asia | 15.20 | 6.6% |
| 16 | Sweden | Europe | 15.21 | 6.6% |
| 17 | Brazil | Emerging Market | 15.77 | 6.4% |
| 18 | Hong Kong | Asia | 16.05 | 6.2% |
| 19 | Taiwan | Asia | 16.00 | 6.25% |
| 20 | Thailand | Asia | 16.34 | 6.1% |
| 21 | South Africa | Emerging Market | 17.44 | 5.7% |
| 22 | Korea | Asia | 18.62 | 5.4% |
| 23 | Canada | North America | 18.86 | 5.3% |
| 24 | India | Emerging Market | 20.06 | 4.98% |
| 25 | USA | North America | 21.76 | 4.6% |
| 26 | Mexico | Emerging Market | 21.69 | 4.6% |
| 27 | Malaysia | Emerging Market | 23.12 | 4.3% |
| 28 | Chile | Emerging Market | 26.40 | 3.79% |
| 29 | Indonesia | Emerging Market | 29.41 | 3.40% |
Clearly, the lowest valuations, and highest expected returns, are in Europe. E[R] range from a high of 13.6% for Italy to 6.6% for Sweden.
U.S. stocks are among the most highly-valued stocks in the world. CAPE is 21.76 and expected return is about 4.6% after inflation. All of the other countries with CAPE above 20 are Emerging Market stocks–India, Mexico, Malaysia, Chile and Indonesia.
Asia stocks are about in the middle, valuation-wise. Japan has E[R] = 6.6%
You can invest in European stock through an ETF such as Vanguard MSCI Europe ETF (VGK) VGK holds 457 European stocks with median market cap of $43.2 billion. The top ten holdings are:
1 Royal Dutch Shell PLC
2 Nestle SA
3 HSBC Holdings PLC
4 Vodafone Group PLC
5 BP PLC
6 Novartis AG
7 Roche Holding AG
8 GlaxoSmithKline PLC
9 Total SA
10 British American Tobacco PLC
**Mebane Faber is the portfolio manager at Cambria Investment Management, here he manages equity and global tactical asset portfolios. He writes a blog called World Beta.
