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Shares are cheap, but are they good value?

Created:
2 December 2008
Written by:
Jonathan Eley

Shares have gotten a lot cheaper in the last few months. With a few honourable exceptions, like pharma and general insurance, every stock market sector contains shares that cost a lot less than they did even a few months ago. Whether this makes shares in general worth buying depends on how their current price stacks up against some measure of their intrinsic value. The trouble is, arriving at that magic number is easier said than done, whether it's for the market as a whole or for individual companies.

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One way of doing this is to look at relative historic metrics. Is the market as cheap as it's ever been in terms of earnings? Has it every yielded more, relative to cash or gilts? The answer is: sort of. Georgina Taylor, equity strategist at Legal & General, says that "on most historical measures, the market has gone through levels reached during the early 1990s and is heading towards the valuation levels of the early 1980s recession." She also notes that the dividend yield on UK shares during October was greater than the yield on ten-year gilts. All of which is positive, although as IC economist Chris Dillow points out, buying into apparently 'cheap' shares has rarely paid off in the past, as they've just got cheaper still (see The lure of the cheap).

Furthermore, valuations based on dividends and earnings assume that these are sustainable. And as Ms Taylor points out, they're not. Dividends from banks, heavily represented in the All-share, are set to all but disappear. Then there's earnings. During downturns, analysts tend to be way too optimistic about earnings, as our columnist Simon Thompson has repeatedly pointed out. Companies have been unusually profitable in the past few years, but returns on equity (RoE) always revert to the mean. Trees never grow to the sky. Simon thinks RoE across top European companies will fall by up to 44 per cent. (see The earnings conundrum). Ms Taylor thinks a 30 per cent drop in average earnings is likely.

The final piece of the puzzle is sentiment. Greed and fear. Here, we turn to the Mr Bearbull's many decades of experience. He borrows a line from the great Wall Street speculator Jesse Livermore - namely, that share prices "will do whatever comes easiest." Right now, it's easier for prices to fall than rise - which is why he is looking, but not buying (see Don't get suckered in).

FINDING VALUE...

You can use our market dashboard or our stock screening tool to find shares with high yields, low PE ratios or strong relative share price performance.

What do you think? Are you buying shares at current levels? Send us your views using the YourOpinion box!

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