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By Nick Renton AM

Share investors are no doubt familiar with the concept of the price/earnings ratio for an individual stock. This ratio is defined as the market price of a share expressed in cents divided by the earnings per share also expressed in cents. The ratio can be described as the number of years’ purchase inherent in an investment in that particular share.

Investors may be less familiar with the concept of the weighted average price/earnings ratio of the overall market – or, more accurately, of all the stocks in a specific stock exchange index, such as the All Ordinaries or the S&P/ASX 200. This ratio is defined as the total market capitalisation of the stocks in the relevant index divided by the total last year earnings of those stocks.

The long term trend for the price/earnings ratio of the Australian market is usually said to be a ratio of around 15. However, as the figures in the table below show, this ratio has fluctuated enormously in recent years and has in the main been higher.

If the ratio is high at any particular point of time then the presumption must be that either the market value of shares will fall or the earnings per share will rise. At least that is the theory. In practice many other factors also influence market prices and thus PE ratios are not a good guide to predicting these.

The market could be regarded as being overvalued if this ratio is higher than past figures or than corresponding ratios in international markets. But, as far as investors are concerned, even if the market as a whole is overvalued then many individual stocks will not be.

It also needs to be pointed out that all published price/earnings ratios have one severe limitation – namely, that they are of necessity based on historical earnings per share. Just before a company’s new annual report is published these could refer to a period that commenced about 27 months ago.

On the other hand, share prices are much more influenced by the market’s estimates of future earnings per share. This means that the published weighted average price/earnings ratio for the overall market suffers from the same limitation.

To illustrate, consider a share with a market value of 100 cents and earnings per share as published in its last annual report of 5 cents per share. This gives a price/earnings ratio of 20.

However, if the market expects that the earnings per share in the next annual report will be only 2.5 cents per share then the market may decide to apply a lower price earnings ratio, say 12, to this figure, giving a market value of 30 cents per share (or 70 per cent less than the earlier 100 cents).

However, the published price/earnings ratio will be the 30 cents per share market value divided by the last published earnings per share figure of 5 cents, giving an apparent price/earnings ratio of 6. This may trap some investors into believing that a purchase at 30 cents would amount to a bargain.

Table 1 below shows the weighted average price/earnings ratios at six-monthly intervals over the last 10 years, together with some other figures for comparison purposes, including the All Ordinaries Index and the weighted average dividend yield.

Table 2 shows as a matter of interest the published price/earnings ratios at the time of writing of six well-known large companies – the two mining heavyweights, BHP and RIO, and the four major banks (ANZ, CBA, NAB and WBC).