Is the stockmarket too highly valued? Is it safe to enter into the stockmarket now?
Some experts look at the price earning ratio of the stocks. This is the current market price divided by the earnings per share. Historically, a ratio of 15 times looks at a fair level. If the P/E ratio is 25 times, it is considered as expensive. If it is less than 10 times, it is cheap.
At the current level of the ST Index of 3,600 for the Singapore market, the P/E ratio is likely to be about 18 times. Some experts argued that it is not too high. So, it is safe (according to this view).
I remember in 2003, the ST Index was at 1,200. If the current P/E ratio is 18 times (ST of 3,600), surely, it must be only 6 times in 2003 (ST of 1,200)?
This was not the case. In 2003, the profits of the companies were about 25% of today. So, the P/E ratio in 2003 was around 24 times. Many experts argued, on the P/E ratio, that you should sell the stocks.
What is the flaw?
It is wrong to calculate the P/E ratio based on the latest year's profit. It is better to use an average of 3 to 5 years to calcuate the P/E ratio, so that the fluctuation in the earnings can be smoothed. Unfortunately, I am not aware of any P/E ratio that is calculated on this smoothing method.
Lesson: Be careful about interpreting the P/E ratio. Try to take the average profit for a few years, so that you are not distored by by extreme results in one year.
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