Prices alone tell us little about value

Prices alone tell us little about value

If I said before the pandemic that you could buy 1 Apple share for $80, you may well have responded that this seemed expensive. Certainly, most traders and economists thought so at the time too. However, now it’s trading close to $150 a share.

It turns out that before the pandemic Apple shares were actually cheap but we only know this 18 months later, and this is only if we compare it to its current price. Was it actually cheap? Not buy any economic theory or measurement of valuation, but if it’s now worth double, then I guess it was.

This really is the conundrum of valuing stocks; they can’t be judged on price alone. If someone offered you a car for £20,000 with no background information, you’d have no idea whether the car is expensive or cheap at that price, because you don’t know anything about the car.

It could be a brand-new Aston Martin, or a worthless bucket of rust, so if you’re trying to work out if something is expensive or cheap then price by itself is no help at all.

The stock market is exactly the same.

Just because the FTSE 100’s current price of 7,000 is 12% below its all-time high, that alone tells you nothing about how attractively valued the FTSE 100 is or isn’t.

So, let’s ignore the markets supposed overall ‘valuation’, and let’s instead focus on how those prices compare to an estimate of the index’s intrinsic value.

The Ratio of price to intrinsic value is what drives future returns

The intrinsic value of a dividend-paying investment is the present value of its future dividends, discounted by an appropriate interest rate.

If we were omniscient, then we would know exactly what dividends the FTSE 100 would pay over the rest of its remaining lifetime; it would then be trivial to calculate the annualised rate of return from those future dividends using a discounted dividend model.

However, we aren’t, so we don’t. Since their future dividends are uncertain, so are their intrinsic values, and that’s why their prices jump up and down so much. Investors’ opinions about intrinsic value change as they digest new news every day.

But we can at least try to estimate the intrinsic value of these indices, and CAPE is one of the better ways to do that.

CAPE – Cyclically adjusted price-to-earnings ratio

This is essentially, inflation-adjusted ten-year average earnings, and by averaging earnings over ten years, we get a much more stable number which should be more closely related to intrinsic value.

The stability of intrinsic value is in contrast to stock market prices, which are excessively volatile because of volatile human emotions rather than volatile future dividends. 

When prices are high relative to cyclically adjusted earnings, we can assume that investors are paying too much for future dividends because they’re overly optimistic about what lies ahead.

And when prices are low relatively to cyclically adjusted earnings, we can assume investors are selling too low because they’re overly pessimistic about future dividends.

When the ratio of current prices to cyclically adjusted earnings (the CAPE ratio) is close to its long-term average, we can assume that investors are buying and selling at prices which are at least reasonably close to fair or intrinsic value.

That’s the theory, and in practice CAPE has proven to be a reasonably good guide to whether markets are expensive or cheap, and whether future returns are therefore likely to be above or below average.

The FTSE 100’s historical average CAPE ratio suggests the index is currently a little below ‘fair value’.

Looking at the FTSE 100, over the last 33 years its price has averaged 18-times its cyclically-adjusted earnings, with a high of 34 and a low of 10.

With the FTSE 100 at 7,000, its CAPE ratio stands at around 15, fractionally below that long-term average of 18

Here’s what that looks like in chart form along with the FTSE 100’s CAPE over the last 30-odd years:

GREEN = cheap, YELLOW = fair value, RED = expensive

One of the main features of that chart is the spike in prices around 1998-2000. At that time if you wanted to invest in the FTSE 100 you had to pay up to 34-times its cyclically adjusted earnings, a record multiple that still stands today.

The chart also shows that returns from that record high CAPE level have been terrible, and in fact the FTSE 100 is barely any higher today than it was in the late 1990s.

With the current level being below fair value today we don’t face those same headwinds. In fact, something that these charts can’t take into account is fiscal stimulus. Quantitative easing and helicopter money, has put a lot more capital into the system, that would have otherwise simply not existed.

When government debt is yielding next to nothing, why would anyone invest in it? This in turn, drives more and more money into the equity market. To put the levels of the FTSE into perspective, this flood of capital has driven the S&P in the US to a CAPE level of 37, even though its 100-year average is actually very similar to our markets in the UK.

We should caveat however, that over the last 35 years, it has been closer to 24, but still nothing like what we’re seeing now.

The team behind Cambridge Futures on TPP, were also quick to point out, when we spoke to them about this, that CAPE also can’t account for the human emotion that causes excessive trend, or more specifically, ‘the retail investor’. 

The public now buy shares on their own and they can do so using leverage. This isn’t a new phenomenon, but it’s new enough to have only really recently started to filter through and effect old school economic theory.

If fair value is around 18, then add the amount of money put into the system by the government, add the millions of pounds being put into the market by the retail investor, and the current ratio could arguably be a lot higher, much like it is in the states.

This is one of the reasons the team are so bullish about the FTSE over the next 5 to 10 years. Retail money will only increase in the UK, and the average CAPE should increase gradually in years to come, to allow for this. It means a higher percentage of overall investment will be put into stocks and leveraged equity derivatives, and taken away from more vanilla investments, therefore adjusting the extrinsic value that drives the CAPE ratio, supply and demand.

Panic selling in March 2020 left CAPE at historically low levels

In March 2020, the FTSE 100 reached its pandemic low of 4,990, some 35% or so below where it had been just a few weeks before.

That wasn’t a pleasant experience, but it left the FTSE 100 with a CAPE ratio of just 11.7; significantly below its actual 33-year average of 18.

The implication was that as long as the pandemic didn’t decimate corporate earnings for many years, the intrinsic value of the FTSE 100 (ie. its long-term future dividend stream) would be relatively unharmed and the FTSE 100 at that level was very attractively priced.

Our traders on The Portfolio Platform thought this, and were right. It was hard to know exactly where the bottom would be, but there is always a bottom. As long as the traders don’t over leverage too soon, and leave some powder dry to stay in the fight, then there was a lot of money to be made.

That is why many funds struggled in 2020, but the average strategy on TPP made 58.8%. When there is opportunity to make money, our traders will take it. Did your IFA or wealth manager take it? Or did you simply make back most of what you lost?

Click here to book in a call with one of our expert traders or directors, to discuss how to go about setting up your own portfolio with The Portfolio Platform.

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