are paying for a share.
Market comparisons
I think the greatest strength of the PE is as a measure of the overall market. For example, the UK market has a long-term average PE of 15, while the world market has a long-term average PE of 16. These can be used as a guide to current value, and help determine the amount of money that should be invested in the different asset classes. When it comes to geographical diversification it can also inform choice. My view is simple: the lower the PE, the cheaper the market and the greater the value on offer.
The following table lists the trailing and forward PEs of the World and UK markets as at end 2010:
| UK | World | |
| PE (2010) | 12.0 | 14.6 |
| PE (2011) | 10.6 | 12.7 |
| Long-term average | 15.0 | 16 |
Source: Factset MSCI Barclays wealth strategy
As these figures for the equity markets are below the long-term averages it would indicate to me that equities at present offer good value and therefore it is an asset class in which the investor should be overweight. This position is also supported by the following chart:
Figure 3.1: PE of the MSCI world Index
The chart shows that using the 1 year forward PEs as your guide, the world markets have been significantly undervalued throughout 2009 and 2010 as the market PEs have been significantly below the long-term average (shown on the chart at just above 16).
I find the PE a better guide to value in the general markets than it is for individual shares.
It also helps to inform the timing of investment. There is plenty of historical evidence that shows the market PE is inversely correlated with subsequent stock market returns. In plain English this means that purchases made when market PEs have been below the long-term average (as they are now) have made more money in subsequent years than purchases made in years when the PE was relatively high.
The Rule of 20
This is a good place to mention what is known as The Rule of 20. This is an equity market valuation method that refines the use of the PE as a guide to value in the overall market. The rule works on the premise that fair value in the equity markets exists when the aggregate of the market PE and the current rate of inflation is 20. If the sum comes to less than 20, the rule suggests the market will rise. Over 20, and the rule indicates the market will fall. The more extreme the figure, either on the low or high side, the more certain the indication. In essence, the rule is a simplified dynamic asset allocation technique.
It’s just a rule of thumb, but one which certainly passes my “3 Box Test” (referred to in the preface to this book). Over the years it has proved a very useful guideline that has helped me to decide whether to increase or decrease the current level of my equity investment.
Conclusion
In summary, I believe the PE is a much better guide to value of the overall market than it is for individual shares. In fact, I would regard the one year forecast PE to be by far the best guide of value when it comes to general market levels.
With regard to individual shares, it is useful but certainly not the complete answer. In the following chapter we will look at what I believe is a better guide for share prices: the PEG.
Note: a table of PE values for the FTSE100 companies can be found in the appendix.
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