6.5 The behaviour of security prices

calculation. It could also be said that in many circumstances the effort is unnecessary

– we are trying to nd out more than we need. The argument here is that the dis-

counting of dividends, using the CAPM, is giving us an absolutevaluation of an

asset. There might be times when this is essential, but what we mainly do with this

absolute valuation is to put it alongside other absolute valuations in order to make

a comparison. In other words, there are many cases where people have already made

the decision to invest in equities (or in bills, gilts, etc. for that matter). The decision

that returns are generally satisfactory has already been made. The crucial decision

now is whether one should buy shares in Aor in Bor in C. For this purpose, all one

needs is a way of comparing the relativevalues of the shares.

One very common way of making this comparison is to use price-earnings

ratios, or P/Es. Phere refers to the price of the share, while Estands for earnings

(or prot) per share. The logic behind the P/Eis that the value of any investment

(for a given level of risk) lies in its ability to earn ‘prots’ or ‘earnings’. The P/Eratio

is telling us the price we are being asked to pay for those earnings, and because both

numerator and denominator are in ‘per-share’ terms, we can make instant com-

parisons across rms of very different size with very different levels of total earnings.

In section 6.2.2 we saw that a rm earning prots of 8p per share would have a

P/Eof 50 if the price of its shares was £4. If the share price of another rm with

earnings per share of 8p were only £3.20, the P/Ewould be only 40. We would be

paying a multiple of only forty times in order to get our earnings of 8p. This applies

regardless of the size of rm, number of shares, total prot, etc. In one case we pay

£4 for a claim to a stream of payments which at the moment is 8p per year; in the

other case we pay only £3.20 for the same claim and this obviously looks a better

deal than paying 50.

Clearly, if we are interested only in relative valuations and especially if we restrict

our comparisons to, say, one particular industry or type of activity where rms will

have similar characteristics, the P/Eratio is a quick and simple way of deciding

between ‘cheap’ and ‘expensive’ rms. On the other hand, the need to restrict com-

parisons to ‘like-for-like’ rms is obviously a limitation. In the last section of this

chapter we shall see that the P/Eratio is part of the standard information about each

company share which is published in the nancial press. We shall also see that there

are substantial variations in P/Es, even within one sector of the market where we

might expect all rms to have similar characteristics. On the face of it, it appears

as though some people are prepared to pay a very high price for earnings per share

when they could pay much less for the same earnings per share from similar com-

panies. This is misleading, however, and it raises another limitation of P/Eratios.

The usual reason for a rm having a high P/Eratio, relative to other rms in the

same industry, is that the market expects its earnings to grow rapidly in future. Thus,

while it might appear that we are paying a very high price for currentearnings, what

we are paying now for the earnings as they might be in two or three years’ time

might be quite reasonable. To dismiss it as ‘too dear’ would be a mistake. This com-

plicates the use of P/Eratios considerably. If the market is correct in its foresight

that high P/Es are justied by future rapid growth, there is no obvious reason for pre-

ferring high P/Eshares to low ones (or vice versa), unless we have a special reason

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Chapter 6 • The capital markets

for favouring future capital growth over current income. How do we know whether

the market is generally correct? The best we can do is probably to look at the recent

growth of earnings. If growth has been poor, we might be very careful about buying

a share with a high P/E, but even then it may be that the market has good grounds

for expecting future growth to be rapid. Why else would the market have bid the

P/Eup to high levels?

Before ending our discussion of share price behaviour, it is worth pausing to reect

on the overall picture that we have drawn and to consider how well it reects the

reality which we think we see.

Remember that our theory says that share prices adjust to give the rate of return

required by shareholders. The rate of return is central, and determines the price.

It is interesting, therefore, that where tradable nancial assets are concerned, the

dominant discourse concerns pricesand not rates of return. It is true that newspapers

report and commentators discuss deposit accounts and insurance and pension

policies in terms of rate of return. But where an asset is tradable, almost all comment

relates to its recent, latest and next-most-likely price movement. Rates of return rarely

get a mention. Does this signify anything? Maybe not. It may be that everyone dis-

cussing asset prices automatically carries the corresponding rate of return in his or

her head and talks only of ‘price’ because it is more convenient than ‘rate of return’.

On the other hand, it may be that the nancial community talks in price terms

because they really are more interested in prices than in rates of return. One can see

why it could happen. For example, if we go back to our share valuation formula,

eqn 6.13, we can see that a price change is part of the rate of return. In the long run,

dividends increase (gis positive). If dividend yields are not to rise to innity (i.e. D/P

is stationary), Pmust also rise. And we all know that investors are in practice very

interested in the capital appreciation of shares (eqn 6.14) which may well be a larger

part of the total rate of return than the dividend yield.

But we know that prices change because of changes in demand, whatever may be

the ultimate cause of the demand shift. A shift in demand causes a change in price

just as effectively if it is the outcome of a (false) rumour about a change in interest

rates as it does when it is the outcome of an actual change. And once we separate the

desire to buy or sell from actual events and link it to expectationsof events, we open

the door to the possibility that demand may shift in response to a wide variety of

forces, ranging from those which might be more or less rational in origin to those

which have no logical connection with asset values.

Let us think about some possibilities beginning with events which are strictly

rational (in the sense we are using here) and then moving towards the more fanciful

(but not impossible). An actualchange in the risk-free rate of interest causes a change

in asset prices because it changes the demand for the asset by changing the present

value of its future income stream by changing the rate at which we discount that

future income stream. Holding the asset when the interest rate changes thus leads

to a capital gain (a positive contribution to the overall rate of return) or a capital loss

(a negative one). It makes sense, therefore, for investors to try to anticipatechanges in

interest rates. In these circumstances, demand will shift, and prices will change when

agents expecta change in interest rates. An expectedevent causes an actualevent. For

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