PE ratios: A new pathway to asset allocation

Investors wanting the best returns would be wise to divide the price of their investment by its earnings return.

PORTFOLIO POINT: Using the PE ratios of different asset classes, we can build expectations of future investment returns from the earnings of different assets. The recent 75 basis point interest rate cuts makes cash a less attractive as an investment – something that looking at the PE ratios of asset classes shows.

One of the simpler, and often quoted valuation tools, is the humble Price Earnings ratio. Calculated by dividing the price of a share by the earnings per share, it gives an investor an indication of how much they are paying for every dollar of earnings their investment will provide.

Consider two investments that cost $20 per share each. The first one has earnings of $2 per share, the second one has earnings of $1 per share. The price earnings ratio of the first company will be $20/2 = 10. The price earnings ratio of the second will be $20/1 = 20.

A reasonable question to ask would be why any investor would buy the company with $1 of earnings? The answer is growth. An investor might be prepared to pay $20 for only $1 of earnings if they expect those earnings to grow considerably faster than the company costing $20 per share with $2 per share of earnings.

This simple analysis leads to one of the roles of the PE ratio – as one of the financial measurements dividing the market into 'growth’ and 'value’ stocks. Growth shares are those with higher PE ratios (implying that investors have higher expectations of future growth), and value shares have lower PE ratios.

There is evidence that 'value’ shares provide higher returns than 'growth’ shares. In Australia the Dimensional Australian Value Trust looks to capture this higher return for investing in value companies without trying to pick and choose individuation shares – rather investing in the section of the market with value characteristics. Over the past 10 years it has provided a return of 8.94% pa (after fees), compared with the simple index return over this period of 7.21% pa (to the end of April, 2012).

I think that there is another potential use of the PE ratio – and that is to compare investments between asset classes.

The PE ratio of cash
The media attention in the case of an interest rate cut is usually that of 'good news from the RBA for home owners’. Sure it is good news for those people with variable interest rate mortgages; their repayments are likely to fall. However, for the rest of the world (who happen to be the majority of people) who have either paid off their home loan or are renting, it might even be bad news as the interest paid on their cash investments fall.

A good cash investment – after this interest rate cut – will pay around 5% interest per annum. That will amount to about $5 of interest over a year for $100 invested, or a PE ratio of 100/5 = 20.

Not too many investors would be too excited about a share investment with a PE ratio of 20 – however, in the case of cash, the fact that you capital is virtually secure (provided a well recognised and regulated bank is used) means you can be certain of getting the interest paid and your deposit returned.

The PE ratio of residential property
The earnings of a property are the income that it produces, less the costs to produce that income.

The average price of a capital city property is $448,000 (ABS – March 2012 – Capital City Price Index). In the ABS 'Housing Occupancy and Costs 2009-2010’ data series, the average rent paid to a private landlord in a capital city was $336 per week. This is now almost two years old – assuming rental growth of 10% of the subsequent two years the rental income is now $370 a week, or $19,240 a year. There are many costs that should be taken out of these earnings (agent fees, repairs and maintainance), however, let’s just assume $2,000 a year for rates leaving $17,240 a year on the average capital city property value of $448,000.

This gives a PE ratio of 448,000/17240 = 26.

The PE ratio for Australian shares
It can be frustrating that there is not a consistent measure of the PE ratio of the Australian share market at any one time. However, the data I use suggests a PE ratio of 13.2 for the Australian market at the moment. This is around half the PE ratio of a property investment at the moment – and it would be reasonable to expect earnings from both Australian shares and residential property to grow at around the rate of inflation.

Gold
As one of the 'wonder asset classes’ of recent years, it is interesting to ponder the PE ratio of gold. Gold does not produce any earnings. So, its price (regardless of what is paid) divided by its earnings always gives a PE ratio of infinity – which is certainly at the higher end of things. This emphasises the 'non-productive’ nature of gold as investment, which is why Warren Buffett describes it as having 'no utility’.

Earnings over a Decade
It is interesting to compare what the different asset classes might provide in earnings over the next 10 years. I have invested a hypothetical $400,000 in each asset class, and calculated the earnings over 10 years using the following assumptions:

  • Cash – making the best assumption we can that interest rates will average where they are now for the 20 years.
  • Gold – no earnings.
  • Residential property – earnings (after council rates) to increase in line with inflation each year.
  • Australian shares – earnings to increase in line with inflation each year (i.e. both sales and costs increase with inflation).

Under those assumptions, Australian shares looks set to deliver investors the biggest pile of earnings over the next decade – although there are many economic variables that can impact this.

Conclusion
Cash should have an important place in just about every person’s financial situation – providing liquidity (ready and reliable access to cash). The recent interest rate cuts, however, have made it comparatively less attractive. A focus on the PE ratio of investments might help us be a little bolder when investment prices fall and earnings are comparatively stronger – letting us follow the Warren Buffet advice to be 'greedy when others are fearful’.