Many investors don't understand the stock market. I remember a friend, a financial editor at a big newspaper, telling me a stock was expensive because it cost $300. That makes no sense; the expensiveness or cheapness of a stock has nothing to do with its absolute price. It's the value of the stock (or the company, since a share is quite literally a fractional ownership in the company) compared to how much money that company can make and whether those earnings are going up or down.
If a stock costs $300 and there's one share, the company is worth $300. If another share costs $1, but there are a million shares, it's worth $1 million. Which is more expensive? The answer is you don't know, because you don't know how much each company makes.
We measure the value of a stock not by its price but by its price-to-earnings multiple. It's the most important thing to understand about stocks. When the PE multiple of stocks is high, stocks are expensive. When it's low, they're cheap.
Multiples go up and down. Investors might be willing to pay 10 times earnings for Royal Bank today, and if it's earning $5 a share, the stock will trade for $50. If tomorrow, investors decide a better valuation is eight times, well that stock is now worth $40. If, on the other hand, the multiple goes to 11, the stock goes up.
The best-case scenario for investors is when both earnings and multiples go up: it's like a turbocharger for your car.
That rare but blessed confluence is not likely going to happen any time soon, but there are reasons to think multiples in general will go up.
Here are four, courtesy of strategist George Vasic at UBS, a global investment bank:
1) Europe's troubles scared investors last year; although far from solved, the situation there is more stable. That might give investors the confidence to revalue shares. For what it's worth, the UBS global-risk indicator is rising and now in neutral territory.
2) Economic growth surprises are proliferating, suggesting investors have become too skeptical. This usually leads to higher multiples.
3) In recent history, every time the PE multiple has fallen by two points or more in a year, it has rebounded the following year.
4) Earnings rose 22 per cent in 2011, but growth is showing signs of slowing in 2012. This is good news, according to the strategist, because "PE changes are negatively correlated to growth, so this also would point to higher multiples in 2012," he said in a note.
To this I would add, thanks to Ben Bernanke, the U.S. central banker, interest rates aren't going anywhere for three years.
It's important to understand small gains in the ratio can produce big gains in the stock market. The S&P/TSX composite index is currently trading at 12.2 times estimated earnings, or a lot lower than its average of 14.5 times. But if the multiple rises modestly by just half a point, the composite index should rise to Vasic's target of 14,000 -- or 12 per cent above its current level. So for a half-point you get 12 points, to make it really simple. Not bad.
Fabrice Taylor is an award-winning financial journalist and analyst and author of the President's Club Investment Letter. Email him at: