How Does One Value A Stock Market Index?

Stock market indices are calculated from the quotes of the stocks of which they are composed. It is therefore a sort of average. If an index rose 2%, then it just means the average share price rose by 2%. The number of stocks included and the exact way the calculation is done, is different from one index to another. For example, the Dow Jones Industrial Average is composed of 30 stocks, the 30 biggest companies in the US. The S&P 500 contains (you guessed it) 500 stocks, weighted by their size, and is therefore more representative for the economy as a whole. Kuala Lumpur Composite Index (KLCI), on the other hand, is composed of 100 top companies stocks. KLCI is a market value weighted indice, where price is weighted relative to the number of shares, rather than their total value.

So how do one determine how a particular index should be valued? Let's take a closer look at KLCI for example. It is now trading at about around 1,300. So is it cheap or expensive? The answer, however, can be very subjective, depending on the data compiled by different investment analysts. In principal, one should look at the forward one-year projected corporate earnings (eg., 2008) for a start. Compare that against the projected fair value of the component stocks, and one will get the Projected Price relative to earnings per share (PE) Ratio. The sum of all the component stocks' PE ratio will become a major factor to the would-be value of the stock index. So if one analyst's view of the forward PE as encouraging, he or she may place KLCI at say 1400, as the fair value by the end of the year. Get the point?

However, there is a major twist here! The key complication here is everyone is entitled to a different opinion. Some may be bullish over a particular stock's future earnings, another may be bearish. So the end result can be dramatically different! For example, a particular analyst may be recommending a buy on our low cost budget carrier, Air Asia but another analyst may recommend a sell (which is true right now, depending on one's ability to buy into Air Asia's growth story versus the high gearing which can be a real risk in view of the company's aggressive plan to expand their planes!) So at the end, I would say, the final decision belongs to the investor's self judgment as to who to believe, based on his or her instinct and knowledge of the matter and economy!

Someone asked me this question....given KLCI was trading at around 1300 in 1993, surely Malaysia's index is considered expensive now given that it is now trading at close to that number. The answer lies in how well companies perform and their projected earnings. At the end of the day, fundamentals and future prospects hold the key to any market rises.

Back to the question, is KLCI index cheap or expensive? Let's look at this table:








(Source: CIMB Investment Bank Research)

At 1300, KLCI is trading at around 14x PE. So judge for yourself whether it is cheap or expensive. It is interesting to see that if we go by the 25-year average of 20x PE, KLCI should be trading at 1,880!!