Is the FTSE 100 over or undervalued at the present time?

 
A useful instrument for long-term valuations is based around Robert Shiller’s CAPE (Cyclically Adjusted PE ratio), which uses ten-year inflation adjusted earnings in the ratio rather than last year’s earnings as is the case with the standard PE ratio.

 

Using one years PE is like standing on a table with three legs, it’s unreliable, but, having 10 years of inflation adjusted data is more stable and provides more reliable information.

Long term CAPE of the FTSE 100 is 19 but the data began back in 1987 and during this time we’ve have had two boom markets (Fuelled by the dot.com bubble and too much credit) which could distort the figures.

 

A more consistent CAPE is from the S&P 500 which has over 100 years of data and stands at 16 so for fair valuation purposes a CAPE of 16 is going to be used for the FTSE 100 as opposed to 19.

 

The price of the FTSE 100 at close of business on 19th February 2016 stood at 5,950.23.

 

10 years inflation adjusted earnings for the FTSE 100 at the end of 2015 was 517. The assumption at present is that earnings will fall during 2016 meaning the long term inflation adjusted earnings for the FTSE 100 at the end of 2016 are predicted to be 510. This is only a prediction so could be higher or lower, we’ll only know at the end of 2016 but 510 is seen by many commentators as a reasonable figure to use.

 

So: 5,950.23 / 510 = 11.67 CAPE of the FTSE 100

 

This figure is below the long term average of 16 and indicates that the FTSE 100 is cheap compared to its long term fair value.

 

Points to note

 

Earnings of 510 x CAPE of 16 = 8,160 FTSE 100 fair value

Long term average dividend yield of the FTSE 100 is 3.5%. Presently the dividend yield of the FTSE 100 is 4.29%. At a level of 8,160 the FTSE 100 dividend yield would be 3.12%.

 

End of December 1999 CAPE stood at 32

 

Height of credit crunch is 2009 CAPE stood at 11.40

 

Summary

 

All factors considered point to the FTSE 100 being undervalued and challenges such as BREXIT, GREXIT, China, falling oil price and policy divergence between the U.S. and the rest of the world being factored in.

 

For long term investors, with an appropriate appetite for investment risk, a FTSE 100 CAPE of 11.67 indicates a good time to invest if a long term investment horizon is applicable. In the short term, as history has shown, expensive markets often get more expensive and cheap markets often get cheaper.

 

‘Past performance is not necessarily a guide to future performance. Investments and the income from them can go down as well as up and you are not guaranteed to make a profit from your original investment’.