Is the bruised market's value real or rotten?

2:01pm Tuesday 13th May 2008

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AS the market recovers some of the heavy losses of recent months, it reminds me of an old tale that just goes to show that valuations in the market can represent nothing like a true picture of a company's value.

The story goes that, in the early 20th Century, a lull on the trading floor of the New York Stock Exchange extended from hours into days. The lads were getting bored and restless.

One afternoon, for want of any better entertainment, one of the traders pulled out an old sardine tin, announcing that he would sell the unique item for no more than a nickel.

Instantly, two jobbers from the Railroads pitch had bid and counter-bid for the tin, pushing the price up to a dime.

Not to be outdone, the swells who traded Texas oil stocks jumped in, doubling the price of the sardines - and again the tin passed from professional hand to professional hand.

Each time the price increased.

At last, the hubbub attracted the attention of the baby of the floor, a wet-behind-the-ears college kid.

Determined to show he could play with the big boys, and taken in by the apparent rarity of the item, he firmly called out: "Ten bucks!"

Right there and then, the bidding ended. Hefting out his pocket knife, the kid punctured the tin, only to be met with the unmistakable stench of rotting fish.

Bewildered and heavily out of pocket, the new boy turned to one of his elders, who had taken a half dollar turn out of the tin an hour previously.

"I don't get it. These sardines are long gone," said the kid.

"Son", said the old jobber, "those weren't eating sardines; thems were trading sardines."

A lesson, then, that you should not enter into an investment without understanding what you are buying.

It is easy to imagine the sardines being sub-prime mortgage debt, the apparently rare and valuable tin its new and wonderful re-packaging.

The trading floor rookie may symbolise those institutions (not that any of them are new to the game) who have written off billions of pounds as subprime investments turned out to be rotten.

Inflationary pressures abound at present. If inflation rises too high then the Bank of England needs to choke it off with higher interest rates.

The Central Bank is walking a tightrope at present, which may explain last Thursday's decision to hold rates.

Increases in borrowing costs are harmful to businesses and, accordingly, to investment in those businesses. As business and consumer confidence suffers, a rate rise is not advisable, but whether it is likely is important when researching potential investments.

How one invests at this juncture depends on how well one has used current and historical data to assess the true value of the market and its constituents.

The young lad in the story didn't attempt to find a realistic value for the sardines.

So what is a realistic value for the market?

The traditional measure is the p/e ratio - simply the share price divided by the earnings per share.

A high p/e can suggest an overvaluation; a low p/e can suggest an undervaluation.

The historical p/e average is 14, the FTSE 100 is currently trading at a little under 12.

* Nick Williams is an investment manager in the Teesside office of Wise Speke, and can be contacted on 01642-608855.

All prices quoted in the article are from public sources. The views expressed are not necessarily held throughout the Brewin Dolphin Group. You should bear in mind that no investment is suitable for all circumstances and it is important to seek expert advice if in any doubt. Brewin Dolphin Limited is a member of the London Stock Exchange, authorised and regulated by the Financial Services Authority.