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Share prices – when is high too high?

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For the third consecutive year, the Australian sharemarket has delivered a return of more than 20%. Yet over the same period, the Australian economy has expanded by a measly 2.2% in real terms. Many shareholders are no doubt now asking the following prudent question:

“If share prices have continued to rise at a rate so far above the rate of growth in the general economy, have they not become too expensive?”

Company earnings support share prices

To answer the above question, an assessment needs to be made of movements in the level of company earnings. Shareholders own the entitlement to the stream of future earnings generated by their company. So in theory, a share price should equal the present value of all future earnings applicable to that share.

Valuation questions are therefore typically answered with reference to what is known as the price-earnings ratio (PER). This ratio compares the current share price to the expected (or historical) company earnings per share, ie:

PER = Price per share ÷ Earnings per share

Should the share price rise at a faster rate than expected earnings, the PER would increase. This would suggest that the share price has become more expensive and less attractive to purchase.

However, in the case of the Australian market as a whole, it would appear that increases in share prices are largely supported by the increase in company earnings. One feature of the current economic cycle is that company profits have increased at a rate substantially above that of the overall rate of economic growth.

Most calculations of the current PER in the Australian equity market come out at around the 14 level. This compares to approximately 15 at the same time last year. The fact that the PER has failed to increase despite the ongoing surge in share prices implies that company earnings have risen at the same rate as share prices. This has allowed the PER to remain at a level comparable to historical averages and similar to those levels applying in Europe and the US.

Market averages can be misleading
Whilst investors can take some comfort from the current ratio of price to earnings, purely focussing on the market average PER can sometimes be misleading. This is because the composition of the market changes over time.
In recent periods, the mining sector has been one of those outperforming the market average. One feature of mining shares is that they have lower than average PERs. Therefore, all else being equal, when mining companies grow in price at a rate disproportional to the rest of the market, the market average PER will fall.
If the mining companies are excluded, our estimate of the PER for the remainder of the market actually shows that there was a marginal increase in the ratio.
Another factor to consider when assessing movements in market valuations is the underlying level of interest rates. When interest rates increase, the average PER should decline as it becomes more expensive to fund share purchases. Interest bearing investments also become more attractive relative to shares. Over the course of 2006, longer-term interest rates increased by around 0.5%.
Finally, the PER is only a reliable indicator of share market value if the implied earnings do not significantly change from expectations. It could be argued that given the economy slowed by more than expected in 2006, then there is a higher risk that earnings growth will fall, thereby putting downward pressure on share prices.


Despite the lack of increase in the market average PER, the Australian stock market has become slightly more expensive over the past year once interest rate movements and the movement in the mining sector are accounted for. Given the weakness in the economy, earnings levels may also be more vulnerable now than they were a year ago.
However, whilst recent increases may have pushed share prices to the upper levels of “fair value”, prices remain well below the excessive levels reached in some previous bubbles or peaks. In 1987 for example, the market average PER was 21 – some 50% above the current level.

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