Why has the Price/Earnings ratio rocketed?

WHY has the Price/Earnings ratio (PE) for UK indices quoted in the financial press rocketed this year?

The PE for the FTSE 100 is an eye-watering 40x, up from just 17x at the start of the year. Bloomberg data is even more extreme – at 57x!

Meanwhile, Citigroup forecasts are a little under 18x, up from 16x. That would be consistent with the index’s ten per cent rise this year and minimal earnings growth. So what on earth is happening? Many UK companies have this year suffered losses that are not deemed to be part of the normal course of their business.

Examples of this include asset impairments, where a business or property is no longer deemed to be as valuable as when it was acquired.

BHP Billiton’s US shale oil and gas business, badly affected by the slump in energy prices, saw assets down by some $13 billion from an original outlay of around $20 billion.

Fines, legal settlements and compensation are another source of woe. Banks have been at the forefront of various scandals, from Payment Protection Insurance mis-selling to market fixing.

The running total for PPI payments to customers is north of £25 billion, and by some calculations could cost almost the same again before the saga ends.

Another source of lower reported profits is the cost of implementing cost-cutting measures, including redundancy costs and plant closures.

Finally, business disposals can sometimes cause a dent in earnings.

The net effect is that some heavyweight sectors have seen big reported downgrades this year on the back of (hopefully) one-off charges, to such an extent that the oil & gas sector (-26x), the mining sector (-158x) and the aerospace & defence sector (-80x) are all on negative PEs. The banks sector PE has risen from 17x to 24x.

The Financial Times and Bloomberg obviously take a “purist” view of one-off charges, whereas most of the investing community tends to “look through” the exceptionals, especially the ones that have no effect on cash flow. John Wyn-Evans is head of investment strategy at Investec Wealth & Investment