A couple of weeks back, I was talking to a group of investor-friends about a company I had just invested in. I was describing its business and my long-term view of how the company might evolve. At the end of it, one of them asked me, “So, tell me about the valuation of this share. You mentioned that it has a trailing price/earnings ratio of 43. Do you mean it will continue to be valued at that PE ratio?” I had to answer honestly – that I have no clue what PE ratio the company would be trading at one,…
A couple of weeks back, I was talking to a group of investor-friends about a company I had just invested in. I was describing its business and my long-term view of how the company might evolve.
At the end of it, one of them asked me, “So, tell me about the valuation of this share. You mentioned that it has a trailing price/earnings ratio of 43. Do you mean it will continue to be valued at that PE ratio?”
I had to answer honestly – that I have no clue what PE ratio the company would be trading at one, five, or 10 years from now. In fact, I don’t think anyone has a clue. What I had confidence in though is the company’s ability to grow its earnings significantly over the long-term based on the characteristics of its business and the value proposition it brings to its customers. And frankly, that alone was enough for me.
Knowing the unknowable
My colleague Morgan Housel once wrote the following, describing his thoughts about predicting a share’s returns, using the S&P 500 (a widely-followed U.S. stock market index) as an example:
“Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That’s really all there is to it.
The dividend yield we know: It’s currently 2%. A reasonable guess of future earnings growth is 5% per year.
What about the change in earnings multiples? That’s totally unknowable.
Earnings multiples reflect people’s feelings about the future. And there’s just no way to know what people are going to think about the future in the future. How could you?
If some said, “I think most people will be in a 10% better mood in the year 2023,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.”
It’s the same when it comes to thinking about Singapore’s share market in general. A one-year outlook for the market is a very common thing you can find in financial media especially when we’re near the start or end of a year. But, if we use Morgan’s logical lens to think about what a one-year outlook means, the prognosticators are essentially guessing on the state of the market’s psychology in the future. Do the prognosticators really know? You tell me.
Making better forecasts
That’s why when it comes to market forecasts, I often like to think in the widest terms possible.
The Straits Times Index (SGX: ^STI) closed at 3,226 points yesterday. According to data from the SPDR STI ETF (SGX: ES3), an exchange-traded fund which aims to mimic the market benchmark, the Straits Times Index is valued at roughly 13.5 times trailing earnings. This thus gives the index a trailing earnings figure of around 239 (3,226 divided by 13.5).
With that as a starting point, I can then plot a chart showing the possible paths the Straits Times Index can take 12 months from now.
Source: SPDR STI ETF website & author’s calculations
As you can see in the chart above, there’s a wide dispersion in the index’s future returns depending on how fast its earnings grow, and how optimistic or pessimistic investors are in the future. The former (earnings growth) we can probably guess within a range; the latter… let’s just forget about it.
Keep this in mind when you are reading about market outlooks and thinking of basing your investing decisions on them. A slight tweak in people’s feelings about the future in the future, and that market outlook would jolly well turn out to be useless.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.