What is fair value for Australian equities?
Posted on 24 March 2010
Today’s assignment – to assess what level might represent fair value for Australian equities. It’s a dubious but necessary task. Numbers will say what you want if you apply the thumb screws often enough. So with that caveat, let’s go to the charts. First up, a look at PE ratios through the lens of monthly average PE ratios:
This chart tracks the monthly average PE ratio using current EPS and a 10 year average EPS for the All Ordinaries. (Note the EPS has been imputed from historical PE data – order of magnitude it should be okay, but wouldn’t take individual data points as gospel.)
Some observations:
- As I have not inflation adjusted the numbers, the 10yr PE ratio will generally be higher than the current PE.
- It’s notable that throughout the noughties, the 10yr PE ratio diverged from current PE as earnings rose rapidly across the period. We’d need to do more digging to differentiate the effect of rising leverage in the domestic economy and the stellar earnings performance of our materials sector – suffice to say, EPS growth was a result of both.
- The March lows of last year were historically significant across the period surveyed (but fell short of the 70′s experience – not shown).
- The long term average for current PE is 13.7x and the average 10yr PE is 21.5x.
Expected earnings growth is clearly a fundamental factor in driving the PE ratio at any given time. So to try and put the PE ratios in context following is a chart of year on year changes in EPS:
We can clearly see the consistent earnings growth that was a hallmark of the low inflation, easy credit noughties. Perhaps of more relevance to our current environment is the post 1987 boom and bust cycle as credit conditions were first eased and then reigned in. The relative stagnation in earnings ultimately lead to 10yr PE dropping through the current PE in the early nineties. There is a lesson in there for today’s markets.
As a cross reference, the following chart maps the earnings yield and dividend yield on the All Ordinaries against the 10 year government bond rate:
Again the noughties reveal themselves as a low volatility and low interest rate period – no wonder it was so easy to venture up the risk curve. It’s interesting that prior to this, 10 year bonds were generally higher yielding than their equity counterparts. This isn’t a long enough data set to say which relationship is the better guide – for example I understand that in the PE’s were also higher than bond rates in the 70′s. Still, with the globe heading into a period where higher long term rates are likely, this isn’t prima facie equity friendly.
Additionally, we can expect dividends to be increasingly important as baby boomers move into full-blown retirement. In this respect, dividend yields may exert a stronger influence in determining valuations across the next decade.
Finally, to bring this into a narrower focus, following is a chart of the PE ratio for the ASX200 (based on 12 month trailing underlying profits) against the 10-year government bond rate. (Note this is a different data set – taken from the RBA’s Bulletin – the tighter earnings yield probably reflects the larger market cap status of the companies in the sample.)
In this wanted to highlight how consensus forecasts are pitching earnings for 2010 and 2011. Assuming analysts have pretty good clarity on 2010 EPS from here, then the big question mark hangs over the ~20% rise in 2011.
Conclusions:
1) Absent another shock, the market could well push higher from here – it’s all about risk appetite after all. With the normalisation of earnings (ie. we have passed through the property and credit write-offs), the PE on 2011 consensus forecasts is around 14.0x with the ASX200 at it’s current level of 4930. The analysts that are pointing to 5500 by the end of the year would suggest that at a PE of 15.6x this represents fair value against an average for the last decade of about the same.
2) However, I’m not a buyer at these levels. Fair value looks more like a PE multiple of 12x in the context of the above charts – which on the same 2011 consensus forecasts would have the ASX200 at 4250. Why?
- We are in a global deleveraging cycle. It may not have occurred to Australian householders yet, but we are an anamoly in world markets. We cannot reasonably expect the steady growth in earnings of the noughties to be repeated. More likely the business cycle will be akin to the post 87 crash, with earnings and valuations responding to changes in credit conditions as central banks alternate between looser and tighter credit conditions. This will cap earnings growth and PE multiples for some time.
- The consensus forecasts for 2011 assume a 20% uplift in earnings from 2010. While perhaps reasonable on the basis of a continued recovery led by China’s demand for dirt, there are considerable risks to this scenario – a US/China trade war, sovereign defaults in Europe, a property correction in Australia etc. For these reasons, it is prudent to discount the probability of these earnings being achieved. I’ve done this through applying a lower PE ratio.
- To put the PE ratio in context, the average PE ratio for the All Ords since 1974 is 13.7x versus that of the last decade of 15.3x. You pick which is the more appropriate long run average to apply to earnings.
- And finally, for the aging demographic an implied dividend yield between 5% and 6% would compare reasonably well to a bond yields.
Note to self – Big picture valuation of markets is an inexact exercise. That’s okay, if you don’t expect too much from it. The intention is not to divine the next 10 point move but rather to build a framework within which we can then make investment decisions – whether it’s asset allocation or stock selection. So when people argue the to’s and fro’s of using trailing earnings versus forecast earnings, accept the arguments as valid. The point is that each method has its flaws and advantages. The best bet is to use them all if you have the resources.
5 responses to What is fair value for Australian equities?
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[...] Posted on 14 April 2010 Following on from our previous reflections on fair value for the All Ordinaries (find it here)… [...]
Very useful fundamnetal anaylsis. Unfortunatley markets have a tendency to defy fundamnetals for a long which is wht we at http://www.MarketTiming.com.au are trend followers rather than market predictors. Trend following means gauging the markets direction using moving averages and its speed (using momentum indicators) and then buying and seeling the market as a whole (using exchange traded funds like STW or VAS) whenour model tells us that the market has changed direction. Check out our website and try a free trial . We are Australai’s first licensed web-based market timing service. America has over 500 such services.
Thanks.
Hi There,
Can I ask where you located the data for this? More specifically the rolling earnings data? I have been looking for this for some time now but no single source seems to have it?
Thanks!
Brent,
It’s been a while since I put this together – I’ll have to dig back through the archives.
Cheers
Rohan