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Beware of bargain valuations in coronavirus market

We look at why investors should beware of ‘cheap’ stocks and pay extra attention to valuations at the moment.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

In normal times, we always say investors should pay attention to valuations.

But, in extraordinary times – such as now – that becomes a lot more challenging. It’s crucial you don’t rely on historic ratios at this volatile time and adjust how you look at companies accordingly.

Treat valuations with a healthy degree of scepticism

The most commonly used valuation metric is probably the price-to-earnings, or PE, ratio. It nicely illustrates the problems investors face at the moment.

PE ratios are calculated by dividing the price per share by earnings per share (as per the below).

PE Ratio = Price per share/earnings per share

Earnings is accountant jargon for ‘profit’. So the PE ratio can be thought of as telling you how much investors are willing to pay for a single pound of profit. In normal times it’s a good way of comparing the valuation of different companies in the same industry or the same company over time.

Most easily available PE ratios, including those on the HL website, are historic PE ratios. This means they’re calculated using last year’s earnings per share figure.

Historic PE ratios can be dangerously misleading at times of crisis. That’s because historic earnings per share often bear little resemblance to what will be delivered in the coming year.

The problems with historic PE ratios

Take a fictional company, ABC Corp. It usually trades on a price to earnings ratio of 25.

The coronavirus outbreak is expected to dramatically eat into profits this year and a global economic downturn means profits could be lower for a long time to come.

In fact investors now expect profit to be 80% lower in 2020 than in 2019, and the shares have fallen to reflect the new expected earnings. Assuming the shares now trade for £5 you end up with something like the below.

2019 2020
ABC Corp. earnings per share £1 £0.20
ABC Corp. P/E 5 (historic) 25 (forward looking)

Looking at just a historic PE ratio the shares look like a steal – five times earnings is an 80% discount to the long run average after all. But based on the profits ABC Corp.’s actually likely to make in 2020 the shares look much more fairly valued. They might even be expensive if the company’s long run prospects have been dented by the downturn.

This might all sound academic. But it’s currently going on across the stock market.

UK shares have on average fallen 19% so far this year, and some by considerably more. Looking only at the historic PE ratios in sectors like oil & gas, airlines and travel companies (to name a few) could give you a very misleading view of value.

It’s hugely important investors form a view on how sustainable profits will be in the current environment. We try and highlight some of the major issues through our share research, but ultimately it’s something each investor has to decide for themselves.

Not just a PE problem

The problem with unreliable ratios isn’t limited to PE ratios. Many other ratios are calculated using historic numbers too.

Dividend yields are particularly notable.

Many companies have already announced they’re cutting dividends or even scrapping them altogether. But historic dividend yields (which use last year’s dividend and again are the ones available on the HL website) won’t show that cut. Yields for troubled companies will look far higher than they are.

A good rule of thumb is to double check anything with an historic dividend yield north of 8% and treat anything showing a yield of more than 10% with a high degree of scepticism.

But there will be exceptions in this kind of chaotic market. Some companies with low yields will cut their returns to shareholders, and some high yielding companies will be able to keep them going.

When it comes to spotting misleading dividend yields there’s no substitute for looking at company announcements – all of which are available on our factsheets.

There are no short cuts in the current market

In the current environment there are no short cuts when it comes to investing in shares. No magic tricks that guarantee you’ll pick winners.

But there are some simple mistakes which should be avoided. Relying on historic ratios at a time when history is being rewritten is one of them.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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