How to tell if a share is cheap

There is no right way to value a stock. Most measures have their pros and cons. But one of the most popular is the price/earnings (p/e) ratio. This takes the share price and divides it by earnings per share (EPS). The lower the p/e, the less you are paying per £1 of earnings. It's quick and easy, which may explain its popularity. But how can you get the best out of it?

Most people work it out by using the latest reported EPS figure, or one based on analysts' forecasts for the year ahead. The trouble is, lots of companies' earnings bounce up and down with the economic cycle (cyclical' stocks, such as miners and housebuilders, in particular). Analysts' forecasts are often on the optimistic side because they tend simply to extrapolate the most recent trend for the years ahead. So is there a better way to do this?

A long-term p/e ratio

Many successful investors insist on being conservative and building in a buffer a margin of safety' when buying shares. This was key to legendary value investor Benjamin Graham's strategy. He suggested that investors base the price they are prepared to pay for a share on the average of its last seven or ten years' earnings. He argued that this reduced the chance of overpaying for a company based on a temporary boost in profits something that became very evident during his time investing during the 1930s depression.

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Graham's idea was revived by Robert Shiller in the late 1980s. Shiller applied it to the entire US market and convincingly (and correctly) argued that American stocks were significantly overvalued during the late 1990s. Shiller's p/e takes the present value of the S&P 500 index, and divides it by the ten-year average profits ofthe index. These are adjusted for inflation (so the profit figure from a decade ago, for example, is increased in line with inflation). The resulting figure is known as the cyclically adjusted price/earnings ratio (Cape), or PE10.

Shiller claims that when the ten-year average of the S&P 500 exceeds 20, future returns will be poor. If it is below ten, future returns are likely to be good. Over the long run, it has been very good at tracking changes in the real (inflation-adjusted) value of the S&P 500, and has been shown by analysts such as Mebane Faber to work in other markets too. It's one reason why we are not keen on the US market the ratio is just over 23 just now.

Capes for individual shares

If you want to find out the Cape for most individual British shares, you'll be disappointed. Private investors won't find this kind of information easily available (although a website for US stocks has just been launched www.caperatio.com). However, you can have a go at working it out yourself. It takes a bit of time and some number crunching, but is quite straightforward with a spreadsheet.

Instead of using share prices and the last ten years' EPS figures, I'd suggest using the market capitalisation (the share price multiplied by shares in issue), and reported post-tax profits. This minimises the chances of EPS figures being distorted by rights issues or buybacks.

The profit figures can be taken from company reports, easily found online. Once you have them, you have to adjust for inflation. You can get the figures for the retail price index (RPI) from the internet. So to adjust profits made ten years ago, you have to multiply them by cumulative inflation since then.

This is worked out by multiplying each separate annual inflation figure since then (for example, 3% inflation for ten years means the profit figure ten years ago is multiplied by 1.34 to adjust it. The profit one year ago is multiplied by 1.03). You then add up the inflation-adjusted profit figures, and divide by ten to get your ten-year average profit. Then divide by the current market value to get the Cape.

But what does it mean? One way to make sense of it is to invert the Cape (one divided by the Cape) to get an earnings yield. Say the Cape is ten, that means you are getting an earnings yield of 10% (1/10) on the company's average profits that's a healthy yield compared to most other investments, which might suggest the share is cheap.

Applying the Cape

Cape works best with companies that have been in the same line of business over ten years, and have volatile profits. Housebuilders are well suited to this analysis. In the table below, I've looked at three companies in the sector and worked out their Capes. Looking at these three, while they are not dirt cheap, the earnings yields still look reasonable, suggesting that the rally in housebuilders could have some way to go yet.