UK stock market overvalued on Buffett’s favourite measure

The PE on the FTSE All-share is also flashing red at 33 times earnings, higher than the peak of 27 times in 2006 before the previous crisis and within touching distance of 36 that was reached before the dotcom disaster.

The figure used in this calculation is the current reported earnings. It is important to point out that UK-listed company earnings have been hit hard by the commodity price sell-off because of the FTSE’s weighting towards oil and gas, and mining. The market consensus is for earnings to bounce back and the forecast PE on the FTSE All-share is a more reasonable 17 times.

That said, the biggest concern is around the future earnings figure as the UK economy begins to show signs of slowing down. The unemployment rate ticked up between December and February, and retail spending is slowing.

Book value

 The PE ratio is a good way to quickly see if the market is looking cheap or expensive. The best way to protect against losses in your investments is by looking at the balance sheet, something not many investors take the time to do.

Working out the net asset value (NAV) per share from the balance sheet, also known as book value, allows investors to understand what the assets are that back up the value of the shares. The NAV is a rough estimate of what the company would be worth if it went out of business tomorrow.

On this measure the UK stock market isn’t looking overvalued. The FTSE All-share is currently trading on 1.8 times the value of its underlying assets, well below the dotcom boom of 5 times and the 2006 high or around 2.5 times.

However, there are reasons this measure could be slightly misleading. Record low interest rates have made borrowing extremely cheap for corporates, and this has allowed unprecedented balance sheet expansion. Bigger balance sheets would keep the price to book ratio artificially low.

Dividend yield

 Another way to look at equities is the dividend yield. It can highlight when the market is offering good value to investors and is worked out by taking the dividend payments and dividing by the index price.

The FTSE All-share currently has a dividend yield of 4.2pc, and this is excellent value when compared to 10 year UK government bonds which are paying 1.6pc. It should be approached with caution. A high dividend yield can also point to financial problems in the underlying companies and cuts to dividends in the future.

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