Investors lose faith in euro stock valuation compass

European shares look cheap according to some traditional measures but investors are finding it hard to judge whether they are a good buy given the potential damage to companies and economies if Greece were to leave the euro zone.
Anyone focused on the often-used measure of how the price of a company’s stock compares with the earnings that analysts expect the firm to report in a year’s time might think it is time to find a bargain.
That is because the price/earnings comparison is 8.5 for the fifty biggest euro zone blue chip stocks, lower than the average of 9.8 over the past five years.
However, few are relying on such indicators these days. Speculation about Greece’s future, general political and economic turmoil in Europe and uncertain global economic prospects mean investors are making several other checks before buying into a stock, sector or index.
“Equities are cheap, no doubt. They can, however, remain cheap: cheapness does not mean one should buy,” said Societe Generale’s global head of asset allocation, Alain Bokobza.
Investors are looking further back in history than they normally would because of the unprecedented nature of some of the potential shocks, notably a Greek exit from the euro.
“Valuation multiples are reasonably cheap but not extreme, especially if we head into a full-blown crisis or systemic event,” said Morgan Stanley equity strategist Ronan Carr.
Current valuations are only modestly below the 85-year average, he said.
This is not low enough for those wary of falling into a ‘value trap’ of the sort that caught out anyone who bought stocks in the past two years by looking only at the cheap price/earnings ratio.
Such a strategy would have consistently underperformed the broader market over this time frame, Bokobza said.
Many equity analysts cut their forecasts for firms’ earnings earlier this year and that has helped to prop up the price/earnings ratio for some stock market indices.
For example, Spain’s IBEX is trading at 8.5 times the expected earnings of the 35 firms in the index, even though the market lost a quarter of its value so far this year.
Colin Robertson, head of global asset allocation at Aon Hewitt, said that means analysts still haven’t been radical enough in cutting their forecasts for earnings.
The number of times analysts are cutting their estimates for earnings is already finely balanced with the number of times forecasts are being raised at the European level, according to Thomson Reuters data.
“We don’t have much of an earnings buffer left before stocks start to become expensive against their five-year average,” Fredrik Nerbrand, global head of asset allocation at HSBC, said. “There’s only room for a marginal decline.”
“I also look at how equities are priced against corporate credit and at the moment they do not look particularly cheap on that level either.”
As the euro zone teeters on the edge of recession, Morgan Stanley’s Carr said another useful measure of earnings potential was the average of the previous 10 years’ earnings: “Looking at forecast P/E can be misleading as it tends to underestimate the size of earnings declines in a recession.”
On this measure, the MSCI Europe index has a price/earnings ratio of 11.2 compared with 9.8 when the 12-month outlook for earnings is used.
For Janet Lear, a member of Deutsche Bank’s CROCI team, which drills into stock valuations, European equities are fairly valued when comparing prices with estimates of how much cash firms are expected to generate in the future.
The forecast return from equities is 5.45 percent in inflation-adjusted terms, which is in line with the long-run average. It was as high as 5.85 percent in March 2009, when stock markets hit their post-financial crisis troughs.
This is a useful gauge as long as the relationship between prices and earnings accurately reflects free cash flow, or how much a firm has to spend on dividends or share buy backs after it has accounted for the cost of running its business costs.
For example, in the energy sector, capital expenditure - the money firms set aside to fund costs such as drilling an oil well - has sapped free cash flow.
Such a snapshot of the health of a company’s balance-sheet is becoming increasingly important as cash-strapped consumers rein in spending and governments try to shore up stretched finances, often by raising taxes.
The utilities sector, which has consistently lagged peers despite being cheap in P/E terms, is a good example, Lear added.
The STOXX Europe 600 Utilities index is trading at 10 times forward earnings but is one of the worst-hit sectors so far this year, having shed a bit more than 6 percent.
Assessing a share price against the value of concrete assets, such as an oil company’s deposits, a car-maker’s factories or an investment bank’s loan book, can sometimes be useful, especially if the earnings outlook is unclear.
A sell-off in European equities has led to many firms trading below the ‘book value’ of their assets, which could suggest they are a bargain.
An index of euro zone banks recently slid to an all-time low and trades on a cheap price-to-book of 0.56 that could be a great buying opportunity.
However, there are caveats. As well as failing to take into account assets such as a company’s brand, the valuation could fall further if Greece exits the euro zone, eroding the value of banks’ assets.
“The uncertainty surrounding Greece’s future in the euro zone is particularly negative for them as their exposure to Greek non-financial corporates, which may default if Greece leaves the euro and devalues, remains significant,” Societe Generale said in a note on global financial stocks.