Above-average returns seem likely for the FTSE 100

Over the last 25 years or so, the FTSE 100 has repeatedly zig-zagged between 3500 and 7000, swinging back and forth between bull market and bear market.

As I write, the UK large-cap index sits at 7400, only slightly below its all-time high of 7800. And yet despite this seemingly high price, one interpretation of the dividend discount model suggests the FTSE 100 is attractively valued, implying that above-average returns are likely over the medium to longer-term.

At first glance that doesn’t seem to make sense. How can the FTSE 100 be attractively valued at near-record prices? To answer that, we need to back up a bit and clarify the difference between the FTSE 100’s price and its fair value.

The idea that price and fair value are not the same is common to all forms of trading or investing. This difference becomes obvious when sellers want to sell quickly for one reason or another. 

For example, someone might part exchange their old car and accept a price far below fair value because they want to get rid of the old car immediately, in order to buy a new car today. The buyer can then make a profit by putting the car on the forecourt and waiting (perhaps for several weeks) until a buyer appears who is willing to pay fair value.

Another example would be someone who inherits a house and then sells it for less than its fair market value. They do this because they want to turn the property into cash now, rather than spending months trying to sell the property for its fair market value.

The same thing occurs in the stock market. Sometimes share prices accurately reflect fair value, but much of the time they don’t. Prices can be below fair value for all manner of reasons, perhaps because people are selling shares to invest their money elsewhere, or they need the cash, or they’re afraid. On the other hand, prices can be above fair value too – typically when the market has had a good run and everyone wants to jump on the bandwagon.