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Does The FTSE Pass My Triple Yield Investment Test?

Pound Coins

Like most private investors, I drip-feed money into my investment account each month. To stay invested, I need to make regular purchases, regardless of the market’s latest gyrations.

However, the FTSE 100 (FTSEINDICES: ^FTSE) is up 75% on its March 2009 low, and is no longer cheap.

So is the UK’s blue-chip index still a buy, or do investors need to look elsewhere?

The triple yield test

Low interest rates mean that the stock market has become a popular choice for investors who want their savings to stay ahead of inflation.

To gauge the affordability of the market, I like to look at three key yield figures — the trailing dividend and earnings yields, and the forecast yield for the year ahead. I call this my triple yield test:

FTSE 100 Value
Current price 6,650
Earnings yield 5.8%
Trailing twelve month dividend yield 2.9%
FTSE 100 forecast yield 3.2%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.7%

The earnings yield is simply the inverse of the P/E ratio, and the FTSE’s earnings yield of 5.8% equates to a fairly high P/E of 17.2

However, analysts are predicting average earnings per share growth of 9% for FTSE 100 constituents over the next year, placing the index on a forecast P/E of 14.7, which isn’t expensive.

Strong earnings growth is expected to fuel a continued rise in dividend payouts, and the index currently trades on a forecast yield of 3.2%, more than double the interest available from a decent instant access savings account, and 0.5% more than 10 year gilt bonds.

FTSE 100 vs. the rest

To put the FTSE 100’s valuation into context, it’s worth looking at the UK stock market as a whole.

2014 Forecast UK Stock
Market
FTSE 100
P/E ratio 14.6 14.7
Earnings per share growth 13.5% 9.0%
Dividend yield 2.7% 3.2%

The figures above show that the UK’s biggest companies are expected to stay true to form, delivering slower earnings growth but higher incomes for shareholders, even though the FTSE 100 forecast P/E is almost exactly the same as the average P/E for the wider UK stock market.

Is the FTSE 100 a buy?

In my view, FTSE 100 tracker and exchange traded funds, such as the iShares FTSE 100 ETF (LSE: ISF), continue to offer an attractive level of income, relative to small cap stocks and government bonds.

However, the FTSE currently trades on a multiple of more than 17 times its members’ trailing earnings. This isn’t cheap, but the index’s 2.9% yield is above the current 2.0% rate of inflation, and if earnings grow as forecast in 2014, today’s FTSE 100 ‘price’ of 6,650 won’t look expensive at all in a year’s time.

Can you beat the market?

I believe that drip-feeding money into a FTSE 100 tracker fund is a good way to develop a solid, income-paying foundation for a stock portfolio.

However, there will always be individual companies that outperform the market by a huge margin -- FTSE 100 member ITV gained 83% last year, for example.

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> Roland does not own shares in the iShares FTSE 100 ETF or ITV.