Overpriced? No, by this measure shares are cheap

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”.

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