Share prices and the total return from owning shares

It's always a good idea to keep reminding yourself that there are only two ways that you can make money from shares. The share price can go up and you can receive dividends from the company. That's it.

Share price growth is driven by changes in company profits and the valuation the stock market puts on those profits such as a PE ratio. One of the big dangers that face investors is when share price changes are mainly driven by changes to the PE ratio which then leads to that PE ratio becoming too high. By this I mean that it cannot be justified by its likely future profits (the weighing machine bit that Ben Graham was going on about).

High PE ratios tell you that people are expecting strong profits growth in the future. This is what can make buying and owning shares with high PE ratios very risky. If the expected growth in profits never happens or enough people think that they won't happen then sentiment towards shares can change very quickly and the PE can go a lot lower leaving investors with heavy losses. This is known in professional investing circles as PE multiple compression and is arguably a major risk facing some shares today.

PEG ratios

Jim Slater first introduced us to the world of the PEG ratio. Here the PE ratio of the share is divided by the growth rate of a company's earnings per share (EPS). Slater reasoned that if you can buy shares where the PE ratio is less than the EPS growth rate - a PEG of less than one - then the shares were attractively priced. Slater himself used to try and buy shares with a PEG of 0.66 or less.

If we return to our list of high PE shares above then you will also see a column added from SharePad for the forecast PEG (fc PEG). This takes the forecast PE ratio and divides it by the forecast EPS growth from City analysts. You will see that most of the shares have PEG ratios of more than 1 and some a lot more than that indicating that they are not bargains on this measure.

PEG ratios can be useful but you need to use them with care. Do you believe analysts' EPS forecasts? I used to be a professional analyst in the City and can tell you that forecasting is very difficult.

Many companies themselves don't really know how much money they will make in the future. They will have a plan and a budget but don't know when the next recession is coming or when a new competitor will show up.

Therefore trying to justify a share's high PE based on forecast EPS growth still doesn't get you away from the risk of losing money from buying and owning these shares. You might get lucky if the good times keep rolling but you will be cruelly exposed to big losses if they don't.

Studying valuation history - changes in PE from bull market top to bear market bottom

As well as looking at a company's current valuation, it is always a good idea to look at its valuation history. Ask yourself whether a share looks cheap or expensive compared with its historical levels.

This is a task that SharePad excels at. SharePad has financial data and daily share prices going back over twenty years for companies that have been around that long. This means that you can do very detailed studies of a share's valuation history.

What I've done in the table above is to calculate the trailing PE ratio (share price divided by last reported annual normalised EPS) at the top of the last bull market in 2007 and the bottom of the last bear market back in March 2009. The PEs can be compared with each other and the current forecast PE. By doing this I can gauge how much valuations have changed.

Let's start with the top of the last bull market.

Bottom of Bear Market March 2009

What is particularly startling is the fall in PE ratios attached to the shares.

All the companies except Hargreaves Lansdown grew their EPS between the top and bottom of the market ranges. Despite growing profits, the damage to their share prices came though the significant reduction in the PE ratio attached to them. This is what PE multiple compression can do to highly priced shares.

However, with the exception of Rightmove, all the shares listed above fell by less than the 48.6% fall in the FTSE All Share index over the same period. Could this indicate that growth companies with high PEs are more resilient?

I am not too sure about this. It is worth remembering that the All Share Index back in 2007 was heavily weighted towards the valuations of banks and financial companies that were hammered by an unprecedented financial crisis. The losses seen by high PE companies in an absolute sense were still very bruising.

That said, the fact that many of the companies had grown their profits limited the damage to their share prices. The real carnage occurs when you get a fall in earnings and PE ratio at the same time. If that happens, you can end up with eye-watering losses.

Since the dark days of 2009 there has been a big recovery in share prices. This has been accompanied by large increases in the PE ratios as well. Associated British Foods, Ted Baker and Rightmove stand out here. Expensive shares such as Hargreaves Lansdown ARM Holdings have just become more expensive.

Are these kind of increases really justified? One way to try and answer this question is to do a quick check on how these businesses have performed since then.

To sum up

1. Remember that shares are priced on expectations of future profits.
2. Sentiment drives short term share prices. This means that shares are often undervalued and overvalued compared with their potential future profits and cash flows.
3. High valuations can be justified if profits growth stays high.
4. High valuations equal high expectations. Disappointment can lead to big losses.
5. PEG ratios can help identify cheap growth shares, but basing investment decisions on analysts' forecasts can be risky.
6. Dividends can lower the risks of high valuations.
7. It pays to study a share's valuation history and a company's past business performance.