This summer the UK stock market hit an all-time high as the FTSE 100 came close to 6,900 points on several occasions in July and August. But does this mean that shares are expensive and how can a potential investor work out if shares are good value? There are many different ways to value shares and over the next few weeks, I am going to cover some of the main methods.
Probably the most simple way to work out if shares are under or overvalued, is by looking at the ratio between the share price and the profit (or earnings) that the share has made.
This is known as the price earnings or P/E ratio. The actual average P/E ratio of the FTSE 100 is between 14 and 18 depending on the number of years that the ratio is calculated over.
The smaller companies that make up the UK market usually have higher P/E ratios than the larger cap companies as the growth potential of newer smaller, more dynamic companies, tends to be higher than the more traditional established companies. The current P/E ratio of the FTSE 100 index as published in the Financial Times is 13.77. This means that the average share prices of the top 100 UK companies is equivalent to 13.77 years of profit, or in other words it would take nearly 14 years of profit before the price paid by the share had been earned. So despite the market being at an all-time high, the FTSE 100 is still slightly undervalued when compared to the long term average. There are several reasons for this.
The index doesn’t take inflation into account, so an index of 6,900 today is not worth as much as an index of 6,900 ten years ago. Earnings have been growing faster than inflation and on average, as an economy grows, the stock market should be expected to increase in value. This doesn’t mean that markets will always rise, they can and will of course fall in value from time to time. At a time when real returns from cash and gilts are negative, there is still room for the UK market to increase further in value over the next few years.
David Hill is a Chartered Financial Planner and Independent Investment Adviser at Hills Financial Planning, 15 Agnew Street, Larne. He can be contacted on 028 28276814, email firstname.lastname@example.org or see www.hillsfinancialplanning.co.uk