What is the FTSE 100 P/E ratio – and does it really matter?
The FTSE 100’s price—to—earnings (P/E) ratio is very closely looked at. However, the headline number can be very misleading.
P/E ratio: What is it?
The price—to—earnings (P/E) ratio is a measure for valuing a company. It does this by measuring the stock price relative to company earnings per share.
Market theory 101 tells us that we should value businesses based on their P/E ratio. The higher the ratio, the more expensive the company is relative to its current earnings. The stock market gives growth stocks (e.g. Amazon, Netflix, ASOS) high P/E ratios accompanied with expectations of high future profits, while value stocks (e.g. Ford, National Grid, UK housebuilders) have low P/E ratios and expectations of lower earnings growth.
What is the FTSE 100 P/E ratio?
Looking at the FTSE 100 P/E ratio should give a snapshot of how expensive the UK stock market is at any one moment, but in actual fact the FTSE 100’s P/E ratio has fluctuated greatly over time. This is partly due to the cyclical earnings of the commodities and banking stocks, but also to an extent a result of the concentration in the index. As of the end of July 2018, HSBC, Royal Dutch Shell and BP alone accounted for 23.9% of the index.
How to interpret the FTSE 100 P/E ratio
A reliable place to source key statistics for financial markets is Bloomberg’s website. When looking at a P/E ratio however, it can make sense to look at the ‘(Best) P/E ratio’, which is an earnings estimate for the next 12 months, rather than the previous 12 months.
The reason for this is that historic earnings can be very volatile in times of economic stress. Looking at the chart below we can see the blue line fluctuates wildly compared to the estimated P/E. In 2009 this was because earnings collapsed in the financial crisis, while in 2016 it was because the natural resources companies became highly stressed when commodity prices slumped.
Forward P/E ratios are smoother than trailing P/E ratios and give a better idea of the market’s future expectations. For example, buying the NASDAQ now on 58 times historic earnings looks quite rash, but the 12—month forward earnings measure puts it on 23.3 times, which is a premium to the FTSE 100’s 13.8 times and the S&P 500’s 17.7 times.
The NASDAQ is definitely not a cheap market, but holders believe this valuation premium is justified because of its superior earnings outlook.
But are you at risk of overpaying for the growth? Delving into this a step deeper, and you might want to calculate the PEG ratio — using both historic and future earnings — which is the P/E ratio divided by the earnings growth rate, to allow a cross—comparison between stocks and indices.
As with many things in finance, looking at just one number may leave you none the wiser.