Over­priced? No, by this mea­sure shares are cheap

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De­spite post­ing rapid gains over the past year, shares are sub­stan­tially cheaper than their long-term av­er­age, ac­cord­ing to one pop­u­lar mea­sure.

Since the EU ref­er­en­dum re­sult the FTSE All Share in­dex – which broadly rep­re­sents the Bri­tish mar­ket – is up by 26pc. The rise has in part been fu­elled by a weak­ened pound boost­ing earn­ings from over­seas, and many have ques­tioned whether the rally is likely to con­tinue.

On a sim­ple price-to-earn­ings ra­tio, look­ing at the value of the share price com­pared to com­pa­nies’ earn­ings, the mar­ket does ap­pear to be more ex­pen­sive than his­tory. How­ever, this has been af­fected by tem­po­rar­ily weak earn­ings from oil and min­ing com­pa­nies, which should re­cover now that com­mod­ity prices have risen.

Look­ing at a longer term mea­sure – cycli­cally ad­justed price-to-earn­ings (Cape) – the UK mar­ket ap­pears much cheaper. Cape com­pares price to av­er­age an­nual earn­ings over the past 10 years, ad­justed for in­fla­tion.

For in­stance, if a com­pany has av­er­age an­nual earn­ings per share over the past 10 years of $1, and the share price is $10, its Cape value would be 10. This method­ol­ogy can be used to value whole mar­kets.

Since 1983, the FTSE All Share has av­er­aged a Cape score of 16.9, but at the end of June it was 14.6, ac­cord­ing to JP Mor­gan As­set Man­age­ment.

This is de­spite the 10-year time frame in­clud­ing the global fi­nan­cial cri­sis, when com­pany earn­ings suf­fered heav­ily. This would be ex­pected to push down the av­er­age an­nual earn­ings fig­ure, push­ing up the Cape val­u­a­tion.

James Ill­s­ley, a fund man­ager at JP Mor­gan As­set Man­age­ment, said that in­vestors’ fix­a­tion on how much shares have climbed “missed the point that the UK mar­ket over­all is cheap”.

Are mar­kets about to crash? Lis­ten to the new pod­cast to find out more: it­sy­our­money.pod­bean.com

Not all indicators of stock val­ues are flash­ing red, says James Con­ning­ton

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