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Price power

17 February 2017

Research shows that starting valuations continue to be an important indicator of long-term stock market returns.

Does starting valuation matter? It is a question that is often debated amongst investors. One of the key variables investors use to determine valuation is the price/earnings (P/E) ratio. This is the ratio of a company’s share price to its earnings per share – it’s a widely recognised measure of the value of equities. In simple terms, a lower ratio indicates better value.

The chart below shows the starting valuation of the UK stock market, in terms of its P/E ratio, at the end of every year since 1974. This is plotted against the real annualised total return that investors would have received over the following decade if they had invested at that point.

A key feature of the chart is the diagonal trend line, which shows the relatively strong correlation between the percentage returns and the P/E ratio at time of investment. 

Please be aware that past performance is not indicative of future performance. 

A high P/E ratio means that investors must pay more for every pound of company earnings (although the level of earnings may, of course, change once they own the stock). A lower multiple means they are paying less for those earnings.  

For those who invest in the market when its valuation is low, as it was in the 1970s and early 1980s, the prospective returns can be very attractive indeed. Investing at the end of 1974, for instance, resulted in a real average return of 18% per annum over the following 10 years.1

On the other hand, if an investor buys when the market is expensive, prospective returns can be significantly lower. Indeed, at the end of 1990s, with the UK stock market gripped by the dotcom bubble, a P/E ratio of 28 (i.e. 28 times earnings) meant negative real returns for investors over the following decade.1

While there is no guarantee that future returns will mirror this trend, the chart suggests that the relationship between starting valuation and subsequent long-term returns is close. Interestingly, the correlation is nowhere near as strong over shorter time periods, when valuation and fundamentals can be highly irrelevant; a further reason to take a long-term investment approach.

“As the chart demonstrates, UK equities are poised to deliver attractive long-term returns from here, but it is as essential as ever to be selective”, says Neil Woodford of Woodford Investment Management. “Even in the dot-com bubble when the market was ludicrously overvalued, there were cheap stocks. Genuinely active managers were able to find ways to make attractive returns, even though the broader UK stock market stagnated for the best part of a decade.”

So what does this mean for today’s investors? The UK stock market’s current P/E ratio of about 15 times this year’s anticipated earnings implies a real annualised total return of approximately 8% over the next 10 years, based on the historic trend shown on the chart.

“This isn’t bad, in our view, especially when compared to the likely returns available from other asset classes,” argues Woodford.

 

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up.  You may get back less than you invested. 

1 https://woodfordfunds.com/words/blog/uk-equities-overvalued

The opinions expressed are those of Neil Woodford as of February 2017 and are subject to change at any time due to changes in market or economic conditions.  This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy.  The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.

FTSE International Limited (“FTSE”) © FTSE 2017. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

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