The price-to-earnings ratio (PE) is a popular measure of company values. It is a mathematical calculation that takes a company’s share price and divides this by the company’s earnings.
In simple terms, the PE ratio is a payback calculation that measures how many years it would take, in company earnings, to recoup the price paid for a particular share in that company. The lower the PE ratio the cheaper the share is in theory. The higher the PE ratio the more expensive the share is in theory.
The chart below displays the historical PE ratio for the Australian Sharemarket.
As can be seen from the chart above, the PE ratio for the Australian Sharemarket has edged above its long term average. This is a direct result of the recent sharemarket rally, where we have experienced increases of about 50% from March to October 2009. The chart also demonstrates how cheap Australian shares were in March 2009 before the commencement of the recovery.
As the Australian Sharemarket is forward looking it is not unusual for share prices to rally in anticipation of increases in future company earnings. It must be said that there is a very good expectation for company earnings to increase as a result of improvements in business and economic conditions. Furthermore, Australia is probably the best placed economy in the developed world having avoided a technical recession throughout the Global Financial Crisis.
What can we take from the above analysis? We believe that the majority of the short-term upside has already been priced into the Australian sharemarket. However, we believe that on a long-term basis the sharemarket still represents excellent value and we expect a normalisation of sharemarket returns toward its historical average.
The test for the Australian Sharemarket will be the next round of corporate reporting. We will have to wait until the February 2010 reporting season for proof that company earnings have increased in line with share prices. It will also be an opportune time to see how business conditions have held up as the Government stimulus measures begin to wear off and the RBA ratchets up interest rates.
The Australian sharemarket will be vulnerable if economic conditions deteriorate, however all indicators are that economic conditions are improving with the RBA to embark on a series of interest rate increases adding to the 0.25% increase made in October. We note that the RBA board meets tomorrow, with most experts tipping a further 0.50% increase in the cash rate.