How cheap are FTSE 100 shares?

AVN28_WALL_STREET_14722fThe FTSE has fallen over 15% from the all-time high of 7122 reached in April. If merely price is used as a judge of value, the FTSE 100 is certainly cheaper than it was a month ago.

However, most investors are slightly more intelligent and sophisticated and utilise a wide range of ratios and tools to measure the value of stocks.

The earnings, balance sheet, sales and dividends of a company can all be used to judge the value, or in crude terms, the cheapness, of a stock or index.

Simple PE Ratio

A widely used measure of value is the Price-to-Earnings ratio (PE), a measure that values stocks on their underlying earnings against the market capitalisation.

There are variations to this metric, mostly focussed on the period of earnings. The historical or trailing PE measures the previous 12 months of earnings against current market capitalisation. The forward PE uses estimates of the next 12 months of earnings.

CAPE

For the purpose of measuring the overall ‘cheapness’ of the FTSE  from a historical perspective, we are going to use the Cyclically Adjusted Price-to-Earnings ratio (CAPE) which was developed by Robert Shiller, a professor at Yale University and a Nobel Prize winner.

CAPE, also known as PE 10, takes into consideration the last 10 years earnings and adjusts them for inflation by using the Consumer Price Index (CPI).  The exercise reduces the impact of fluctuations to earnings caused by an outlying year and the inclusion of the Consumer Price Index adds to the historical relevance of the ratio.

FTSE 100

So, to the FTSE 100, the current CAPE of London’s leading index of shares is around 13, well below the long term average of around 20. This suggests that currently, if earnings growth maintained, the FTSE 100 is arguably cheap and present a favourable entry point for long term investors.

The highest recorded point of the FTSE 100 Shiller PE ratio was during the Dot Com bubble which saw a huge number of companies’ share prices rising, despite having little or no earnings.

It is important to remember that as this measure takes into consideration the whole index, there will of course be companies that outperform the index and create excess returns when compared to investments that track the overall index. In the same light there will be companies that will underperform the index.

This highlights the need for strong stock picking skills and a degree of experience in timing of entries and exits of stocks. Investment managers and advisory stock brokers will utilise such ratio as the CAPE PE on a daily basis and cut out the complex calculations for individual investors as they present recommendations.

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