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Re: [sharechat] More on the marrket risk premium

From: "Fiona Phibbs" <>
Date: Wed, 26 May 2004 16:11:04 +1200

Hi Snoopy

> I think you have to look back in history to find out what high, average
> and low really mean.    'Apparently' the long term average P/E ratio for
> US shares is around 15  (I think that is DOW type shares, not
> NASDAQ).  That corresponds to an earnings yield of 6.66%.
> When a market crashes, not all shares crash.  Of those that do crash
> not all crash by the same amount.  Based on the assumption the
> higher a share is, the further it has to fall, one strategy might be to
> keep all the shares you own on a P/E of less than 15.    If you can't find
> any shares you want to own with a P/E of less than 15, that might be a
> signal to get out of the market completely!
> Of course you have to remember there are two ways a P/E  can fall.
> The price can go down, or the earnings can go up.

I agree and keep a close eye on P/Es as well, but I am also a little bit
wary of this approach.  Just what is an acceptable P/E for the market?  For
example, I used to look at information from the 80's - a company, say
Cavalier, might have a PE of 8 then but is selling at a multiple of 16
today, is it overvalued today?  Not necessarily, it may depend on the inputs
to the multiplier at the time. As you know the P/E multiplier can be
restated as - P/E = D1/E1 /  (k-g)  so is therefore greatly influenced by
prevailing interest rates (inflation), ROEs, and dividend payout ratios.
This could explain one reason why companies in the 80's traded on lower PEs
than today, for one the denominator was higher, mainly because of high
(inflation) interest rates, and there is evidence that ROE's were lower.
There is also evidence payout rates were slightly higher then, increasing
the numerator, but generally the greater spread in the denominator resulted
in lower PEs.  You are right the long term mean between 1977-2001 is around
15.   The PE in the US in 1986 before the stockmarket crash was only 12.5
(admittedly it was high by historic comparison).  If you take out the high
interest rate, inflation years - which had low PEs then you could argue a
more realistic 'average' for comparison with todays companies in a different
environment might be 22 or so, unless you believe high interest rates
(inflation) may return.  I noticed that you didn't consider those years when
calculating your expected return for shares.  It seems to me using an
'average' PE could possibly result in overestimating the amount of 'fresh
air' in market prices. What do you think?

> OK, if that is what you believe how do you reconcile your DDM model,
> which let me remind you, valued WRI at $1.21?    Your model is telling
> you WRI is 20% overvalued at $1.40, yet you are not selling.

I don't think valuation is as simple as using a single criterion do you?
Even the professional valuers may seek consensus from several methods.  For
example with WRI I might look at a relative sales multiple which indicates
that in comparison to its peers it still offers good value.  I might
consider that the fantastic yield I'm getting hard to replace and there may
be nowhere else suitable to put the proceeds, or get a comparable return, I
may be using the income to live on, or to purchase 'growth' companies, thus
the risk of holding an 'overvalued' share may be relevant for me at this
particular point in time.   Even WB holds 'overvalued' shares doesn't he?

cheers Dean

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