Something dramatic has been going on with the valuation of the FTSE 100 in recent months. And it’s scaring the bejesus out of some investors.
If you look at a five-year chart of the Footsie’s price-to-earnings (P/E) ratio, you’ll see that for much of the period the P/E was in the teens. Indeed, as recently as January, it was bang in line with the index’s long-term historical average of 16.
However, in February, the P/E began to climb steeply. This week it’s reached an eye-watering 35. It’s no exaggeration to say that the Footsie is now insanely expensive.
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What’s going on?
The explanation for this phenomenon is really quite straightforward. The dramatic rise in the P/E has coincided with the release of annual results by the many companies with a calendar year-end, and more recently, by those with a March year-end. A fair number of companies have posted massively battered earnings. As these numbers have fed into the system, so the P/E of the Footsie has rocketed, because while the ‘E’ side of the ratio has fallen dramatically, the ‘P’ side — the level of the index — has changed little since the start of the year
Royal Dutch Shell, the index’s biggest constituent, reported a gut-wrenching 87% collapse in statutory earnings per share (EPS) for 2015 and even on an ‘underlying’ basis, the drop was a staggering 53%. Earnings over at BP were similarly crushed and were actually negative on a statutory basis. Mining giant Rio Tinto was another to post negative statutory EPS and a fall in excess of 50% in underlying earnings.
But depressed performances haven’t been confined to the troubled natural resources sector. GlaxoSmithKline, HSBC and Vodafone are just three top blue chips from varied industries to have posted year-on-year EPS declines.
Look forward, not back
While the FTSE 100 looks grossly overvalued when looking in the earnings rear-view mirror, prospects for the remainder of the current year and next year are cause for optimism.
Some tremendous earnings rises are forecast. An expected easing of oil’s supply/demand imbalance towards the end of this year is behind 2017 EPS growth forecasts for Shell and BP of 77% and 113%, respectively. Miners’ earnings are also expected to start recovering next year.
Meanwhile, other heavyweight stocks are set to see an earnings rebound due to investment and self-help measures coming through. After five years of falling earnings, Tesco is forecast to post a 145% rise this year. GlaxoSmithKline’s four-year drought is set to end with a 15% increase. Vodafone is expected to post an 18% uplift and Barclays is forecast to get back on track, delivering a 50% rise in earnings next year.
And there are some attractive forward P/Es around. Barclays and Lloyds are both on single-digit ratings, as are insurer Aviva, engineer GKN and British Airways-owner International Consolidated Airlines. Plenty more companies are on forward P/Es at or below the FTSE 100 long-term average, and there are many others only modestly above.
So, while the trailing P/E of the Footsie suggests companies are insanely expensive, forward valuations suggest there are some great blue-chip buys — and, indeed, that a humble index tracker wouldn’t be a bad bet.
There could be short-term market volatility, with the Brexit vote, oil-price movements and Chinese economic data all likely to see investor sentiment swinging this way and that. But being able to buy great businesses at depressed prices during times of uncertainty is a godsend for long-term investors.
