The Earnings Multiple: How Markets ‘Put a Price’ on Earnings

In today’s Markets and Money we want to discuss valuation…or how markets ‘put a price’ on earnings. With 2012 finishing on a bullish note, we think it’s an especially important concept for investors to think about going into 2013.

If next year is going to be much tougher, the stock market is not showing any hint of it. In fact, it’s heading relentlessly higher. Domestic interest rates are on the slide, China’s squeezing a bit more out of its credit bubble (giving the impression the Chinese economy has bottomed) and Japan wants out of its deflationary malaise…it’s trying something new…more stimulus!

One of the few bulls in the office, Australian Small-Cap Investigator editor Kris Sayce, has picked this rally very well. He’s been bullish since June. If you think central bank stimulus can keep this rally going, we suggest you suss out Saycey’s latest picks.

But try as we might, we just can’t get bullish. Fundamentally, we think the economy will weaken in 2013. That means we should see company earnings come under pressure. Despite this, a rising market tells you investors are willing to pay a higher price for those earnings. In other words, the market’s ‘earnings multiple‘ is expanding.

Let me explain…

When the price of a stock rises faster than its earnings, the earnings multiple grows. For example, BHP might have flat earnings for three years (that is, zero earnings growth) but if the market ‘prices’ those earnings on a multiple of 15 times, whereas three years ago it put a price on BHP of just 10 times those same earnings, then you get a 50% increase in the market price of BHP shares, courtesy of a rising multiple.

A rising multiple also implicitly suggests investors see less risk in buying stocks. The inverse of a company’s earnings multiple is called the earnings yield. So if BHP trades on a multiple of 10 times earnings, its earnings yield is 10%. But on a multiple of 15 times earnings, the earnings yield drops to 6.66%.

In other words, the higher the price (for a given level of earnings) the lower your expected future return. And the lower the price, the higher your expected future return.

This tells you nothing about the future direction of the market. It may continue to surge higher from here and reward the speculators…or the smart operators who know how to play in a monetarily warped market.

But for simpletons like us, we look at the fundamentals and we don’t like what we see. Wealth never was and never will be created by central banking policy. And as far as we’re concerned, the equity market is the epitome of wealth creation. Holding equity in a business is the only way to create genuine wealth.

Central banking can provide a short term boost to markets – we don’t doubt that. But for a prudent investor focused on preserving wealth, it’s a dangerous game to play. Because things can turn VERY quickly.

We were reminded of this early this morning when reading through John Edwards’ article ‘Turning history on its head’ in today’s Financial Review. Edwards suggests we’ve just gone through the third prolonged period of prosperity in our economic history.

The first was the gold and wool boom from 1850 to 1890. The second was the post-World War II boom from 1945 to around 1967. The current expansion began in 1991 and peaked in 2011. What happened after these periods of prosperity?

In 1890 Australia suffered a dramatic bust. The 1970’s were a turbulent economic decade. What happens following the latest period of prosperity we don’t know…but history tells us it will be different from what just happened.

But it doesn’t really matter. We’re all just individuals trying to get through this journey as best we can. And whatever comes next, we’ll all get through it. Some of us will enjoy personal booms while others go through busts. No one knows what the future holds, whether for us as individuals or society as a whole.

While that uncertainty doesn’t stop us from reckoning, it does fill us with humility and awe at the endless possibilities that life offers…if you’re willing to give it a crack. So whichever way this latest period of national prosperity morphs, ignore it and create your own boom.


Greg Canavan
for Markets and Money

From the Archives…

The Trade Deficit Dilemma That’s Alive and Well
14-12-12 – Greg Canavan

The Fed’s Poppycock Monetary Policy Targets the Unemployment Rate
13-12-12- Dan Denning

The Price of Risk in the Stock Market
12-12-12 – Murray Dawes

Recessions the World Over
11-12-12 – Dan Denning

A Victory Over the Zombies!
10-11-12 – Bill Bonner

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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