Market PE ratios

Market PE ratios

The one-year forward price-to-earnings (P/E) ratio for the S&P/ASX 200 index has varied significantly over the past few years. In 2011 it fell to 12 times, and recently market participants have been sufficiently enamoured to push the ratio as high as 16-17 times.

At present, Bloomberg estimates the forward P/E ratio of the ASX 200 to be 15 times 2014 earnings. This level is within the range recorded over the past few years, and also in the 14-15 times P/E ranges that the Australian share market has traded on average since 1970.

Despite this apparently modest reflection of relative enthusiasm, we have recently read many articles suggesting ‘bubble’-like conditions currently exist. So what should you make of it?

 The Australian share market as represented by the ASX 200 index at any time represents the “price” of the market as a whole. In a perfect world it should also represent the present value of future earnings estimated by the market as a whole. From the information provided, we should be able to solve for the expected earnings of the index, by simply taking the current ASX 200 index price and dividing it by the P/E.

Now, the value of a share of a company is simply the sum of future cash flows (we assume the earnings are a proxy for this) discounted back to today. The value of any index is also simply the sum of the future cash flows of each of the constituent companies discounted back to today. Using this estimated earnings number, and the discounted cash flow formula, we can quickly estimate the assumptions for future growth the market is implying at its current level, explaining why the market trades on an earnings multiple of X and examine whether or not this is rational using history as our guide.

By dividing the current index level of ~5,500 by a P/E of 15, we obtain earnings of the entire market of ~$366.6, upon which we can apply the discounted cash flow (DCF) formula, rearranged to solve for the growth rate the market is assuming.

Using the Gordan growth model as our base, we can simply discount the market’s estimated earnings of $366.6 by the average cost of equity (COE). We will use 10% as the COE, as this is the historical average.  We then solve for the growth rate (g).

Expressed algebraically, the market’s growth expectations are estimated thus: 5,500=366.6/(10%–g).

Since 1970, Australian economic growth has averaged 3-3.5 per cent per annum. Over the long-term, we would also expect earnings for the businesses that make up the ASX 200 index to approximate GDP growth on average over the long-term – provided failed and delisted companies are taken into account.  Survivor bias of course ensures the reported earnings growth rate of the ASX indices looks far more favourable.

If we factor in a 3 % growth rate into our formula, we obtain an index valuation of 5,237. At 3.5% we obtain an index valuation of 5,640. At the present ASX 200 index valuation level of 5,500, the long-term growth rate being implied by the market lies somewhere in between 3 per cent and 3.5 per cent.

Therefore on a current 1 year forward P/E of 15, and adopting a 10 per cent COE, the market is implying a long-term growth rate in earnings of ~3.4 per cent which is precisely where we are today.

You might believe given the dominance of the large banks and miners in the index, that the market cap weighted COE could be lower. If so, it suggests the implied growth rate of the market at today’s level is lower again. In other words, the market might not be expensive at all and certainly is not in a bubble.

At various market P/E levels (assuming a COE of 10%), we also can back-solve the growth rates. At a P/E of 12, for example, the market is implying a longer-term growth of 1.7%. This is well below Australia’s long-term trend and whilst a period of subdued growth is typical in any market cycle, history shows that by taking a long-term view, even the worst economic disasters prove to be temporary in nature.

If we were to assume the P/E of the market as a whole was 10, earnings would simply be capitalised at 10% = 366.6/ (10% – 0%) = 3,666 as a fair valuation for the index. This effectively means that there is no future growth priced in the market at that point. This is, however an unrealistic long-tem assumption and really only likely to occur under extreme short-term circumstances such as the GFC when the economic outlook is extremely confusing. Zero growth, however, is not an assumption the market hangs onto for long, and inevitably after every crash, more rational expectations return. We can therefore consider 3,667 as a base level of support for the market and any time the market heads below this level (assuming interest rates are approximately where they are today) is cheap.

One take-away from this simple expression of the market is that you should be careful with your equity exposure when the market begins implying growth in excess of that of what has been achieved in the past on a long-run basis. For it is then that the bubble-like pricing may exist. That, however, does not appear to be the current picture.

We do not appear to be experiencing bubble-like conditions. At current ASX 200 index pricing levels, the market merely appears to be expecting the Australian economy to grow around historical trends for the foreseeable future. And, even if interest rates were to rise modestly, there is still room for the market to produce gains in the short run.

Finally, keep in mind that any attempt to value the market is not a prediction of its near-term direction.