The best stock valuation method is the PE10 which uses the ten year inflation adjusted corporate earnings to determine a PE ratio. The WSJ had an article about this. If below 15 then it may be time to buy, if over 15 it is time to either hold or to reduce holdings. However the ratio must be carefully fine tuned in other countries. PE’s are much lower in Russia, Brazil, China, Greece. This is because there is significantly more risk and the “real” interest rates and foreign currency rates differ greatly so one must not compare one country’s PE with another. Investors should seek independent financial advice about how to carefully apply the concepts behind PE10.
For example, in Brazil the “real” rate of interest is much higher than in the Developed world. The benchmark cost of capital is one of the factors in determining a discount rate for stocks. You start with the risk free Treasury interest rate and then add on a risk premium for equities. If a country’s currency is headed for a fall then that further complicates how to use the PE10. If the U.S. long term cost of “BBB” credit grade debt capital for corporations has been 6% and the inverse of that is 16 that provides a theoretical framework for which an equilibrium PE ratio should be close to 16. The difference between the yield on BBB bonds and Treasuries roughly parallels the risk premium for equities.
So if one is calculating a PE ratio for Brazilian stocks they might use a much higher yield for Brazilian corporate bonds than for the U.S. bond market to build a foundation for estimating a fair value PE ratio. If rates are 13% in Brazil for corporate bonds, the inverse of 13% is 7.7, which implies fair value PE ratio might be roughly 8, not the U.S. fair value of 14 to 16. To a certain extent the risk premium embedded in high yield EM debt is handy shortcut that incorporates things like EM political risk, local inflation and real interest rates. However one should try to estimate a long term average yield so as to avoid being fooled by temporary periods of booms when capital inflows to an EM country made interest rates go down more than they should. After all if you believe in the PE10 for socks then why not also use a ten year average of local interest rates to build a foundation for a locally relevant PE10.
Regarding calculating a PE10 for China stocks one would need to calculate a true fair market interest rate for corporate bonds and that is difficult since bank loans, in real terms, have an artificially low rate. In addition some investors doubt the reliability of corporate accounting in China. The problem with evaluating PE ratios in EM countries with significant governmental controls over interest rates and currency values is that the foundational data may be significantly distorted both in terms of artificially low rates and in terms of lack of a free market to test what should be the equilibrium rate of interest. Even though the U.S. has had bond prices warped by the Federal Reserve Quantitative Easing there is still a lot of freedom for the market to calculate the spread for corporate bonds, etc. and then one can make some assumptions what the appropriate interest rate should be.
In the U.S. the PE ratio for riskier industries like oil and banks was often about 10 while industrials were at 15. The reason for the lower PE was because oil and banks are more volatile. Another reason for a low PE is the “Value Trap” where a company’s stock price drops even when earnings are steady, because the market anticipates that the company will be heading into trouble.
It may be that the glory days for EM economies are behind them and now they will have to deal with the following: 1. They have maxed out the easy gains from excessive, ever-increasing use of debt. Future new debt will result in diminishing returns for corporations. 2. The ability to sell things to Developed countries made by low cost unskilled EM labor has diminished because of rising wages and will be replaced with a trend where Developed countries are selling sophisticated things to EM countries. 3. The advantage of EM countries with a dictatorship that had no social welfare expenses has been partially replaced with democracy and the same high cost / high tax welfare state problems that Developed countries have. This has further eroded the cost advantages of EM countries. As they become just like a Developed country they will find the Developed countries have an edge because Developed countries have more experience in handling these issues. Thus I am inclined to believe that low PE ratios for low quality, high risk businesses are not a sign of good value.
Buffett often buys slightly expensive stocks because he feels a quality company is very important rather than simply getting a mediocre one with the lowest PE ratio. However my interest in PE ratios is for macroeconomic cycles and is not applied against an individual company in the same way that it would be applied against a broad market index. Even if paying extra for a quality stock is good it still should only be bought if its price is low or moderate in proportion to other relevant benchmarks. Based on quality of earnings and accounting I believe the U.S. is the best and the low PE’s of EM countries are not an applicable way to judge those markets in direct comparison with U.S. PE’s. If you want to own Russian stocks in hopes of benefiting from low PE ratios just ask some Western investors who had problems there.
Investors should seek independent financial advice about how to protect their investments from bubbles by using PE10. I wrote an article about “How can investors decide if stocks are bubble?”