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IS
THE TORONTO COMPOSITE S&P/TSX INDEX (TSX index) FAIRLY VALUED AT THIS TIME? (October
11,
2008)
This question can be explored mathematically by looking at the current
level of earnings and dividends of the stocks that make up the S&P/ TSX
index, projecting the future rate
of earnings and dividend growth and then considering the minimum return required
by investors. Analysts often apply such valuation calculation techniques to
individual stocks. It is actually far easier to apply these calculations to a
stock index since an index constitutes a portfolio and therefore eliminates most
of the random noise of unexpected events through diversification. Still,
many challenges remain in applying this analysis and its results while providing
some indication for the long-term and offer no insight for the short-term. The index
remains vulnerable to changes in interest rates and to growth in the economy but is largely insulated
from the numerous random events that can impact an individual stock. (Although,
keep in mind that the TSX index is heavily concentrated in energy and in
financials and therefore it is not as easy to predict as would be a more fully
diversified market index).
As of October 11, 2008, the Toronto Stock Exchange index was at
9,065 and had a
Price Earnings Ratio ("P/E") of 11.2 based on trailing earnings and a Dividend yield of
4.49%.
(Source:
http://www.tsx.ca/HttpController?GetPage=MDFIndicesView&SelectedTab=QuoteResults
&Exchange=T&IndexID=0000&OpenIndex=&Market=T&Language=en)
Based on its index value and P/E the earnings on the
Toronto stock exchange in the last year (based on the latest available quarterly
reports) was $812. It is important that before starting the analysis we be
satisfied that this is a representative level of earnings from which to forecast
the future. We want to avoid using an earnings figure that is affected up or
down by large unusually events or that is from the bottom of a recession or the
top of the economic cycle. In fact this $812 is from the top of the economic
cycle ending Q2 2008. Since then commodity prices have declined sharply and the
economy has cooled. We do not have available analyst forecast earnings for the
Toronto index for 2009. However, we feel it is prudent to use a lower earnings
number of $700 as being more representative of "normal" economic conditions.
The Toronto Stock Exchange represents a portfolio of about 280 stocks
and Income Trusts. For each
$9,065 (the index value) purchased, the underlying companies in the portfolio,
in the last year earned $9,065/12.95 = $700 (as adjusted) and currently pay a dividend of $9,065* 0.0449 = $407
per year.
When we Buy the TSX Composite index, we can therefore think of it as
being an investment or "stock" that (as of October 11, 2008) costs $9,065 and
currently earns $700 per year (adjustedl trailing earnings) and pays a dividend of $407 per year. It is worth thinking
about whether or not this "stock" is a good investment at or around its recent
level of 9,065.
We know that the Toronto Stock Exchange index was at
9,065 on October 11, 2008. We can estimate
what the TSX "should" have been trading at based on the value of its
current earnings and
dividends and the projected growth in those earnings and dividends. This
intrinsic value approach calculates the value of the projected earnings and dividends for a ten
year period and then assumes that the index is sold at a projected future P/E.
In addition to the beginning earnings and dividend level,
three additional factors are required to calculate the fair value at which the
Toronto Stock Exchange index should
be trading at. These are, 1. The forecast average annual growth rate in
earnings and dividends over the next ten years (using an assumed ten year
holding period for analysis purposes). 2. The forecast P/E ratio at
which the TSX index will be trading in ten years time . 3. The estimated rate of
return required by investors.
Before beginning the analysis, we should ask if the current
earnings level on the Toronto Stock Exchange index has been materially affected by any unusual items,
that make it unrepresentative. At the current time, the economy is strong and
oil and gas and many other commodities are at high levels. Therefore, some would
argue that the TSX earnings may be higher than a representative sustainable
level. However, for the purposes of this analysis I will assume that the current
earnings are in fact representative and sustainable.
The TSX portfolio average earnings should (in the
long run) grow at a rate
close to the growth rate of the Canadian economy in nominal (after inflation) terms.
I believe a prudent estimate for this growth rate is 4% to 6% and I would
focus on 5%.
The average P/E for the Dow Jones Industrial average since
1950 is just over 15. (This is based on year-end data and excludes 1982 when the P/E
went over 100 and a cople of other years where the P/E spiked due to abnormally
low earnings - I don't have the average for the TSX) However the Justifiable
P/E changes (fairly dramatically) with earnings expectations and the
market's required return on equities.
I have conservatively calculated that the current Justifiable P/E
- for the overall market - is in the range
of only 12.5 to 15, even with today's low interest rates. This
conservative calculation of the justifiable P/E assumes that, on average, the
TSX companies will only earn, on new investments, the 7 to 8% minimum ROEs
required by investors in today's low-interest rate environment. If companies can
sustainably earn more than ROE required by investors, then it is possible to
justify a P/E in the 20 range. The more optimistic we are
about the level of the P/E in ten years time, the higher is the justifiable fair
value level of the TSX index today.
The following table calculates the value that the TSX index will be at in ten years given various forecasts for the earnings
growth and given various scenarios for the forecast P/E ratio that will apply at
that time. The last column of the table then shows the fair or present value
that we should be willing to pay today for the cash flows that would result from
ten years of dividends plus the assumed cash from selling the index in ten years
time. The present value is calculated based on various scenarios for the
required return or discount rate.
|
TSX Composite Current Annual Earnings |
TSX Current Dividend |
Earnings and Dividend Growth |
TSX P/E forecast in 10 years |
Resulting TSX Composite in 10 years |
Required Return |
TSX Composite Fair Value Today |
|
700 |
407 |
4% |
13 |
13,470 |
7% |
10,340 |
|
700 |
407 |
4% |
15 |
15,543 |
7% |
11,394 |
|
700 |
407 |
4% |
17 |
17,615 |
7% |
12,447 |
|
700 |
407 |
4% |
13 |
13,470 |
9% |
8,862 |
|
700 |
407 |
4% |
15 |
15,543 |
9% |
9,738 |
|
700 |
407 |
4% |
17 |
17,615 |
9% |
10,613 |
|
700 |
407 |
5.0% |
13 |
14,823 |
7% |
11,210 |
|
700 |
407 |
5.0% |
15 |
17,103 |
7% |
12,369 |
|
700 |
407 |
5.0% |
17 |
19,384 |
7% |
13,528 |
|
700 |
407 |
5.0% |
13 |
14,823 |
9% |
9,594 |
|
700 |
407 |
5.0% |
15 |
17,103 |
9% |
10,557 |
|
700 |
407 |
5.0% |
17 |
19,384 |
9% |
11,521 |
|
700 |
407 |
6% |
13 |
16,297 |
7% |
12,151 |
|
700 |
407 |
6% |
15 |
18,804 |
7% |
13,426 |
|
700 |
407 |
6% |
17 |
21,311 |
7% |
14,700 |
|
700 |
407 |
6% |
13 |
16,297 |
9% |
10,386 |
|
700 |
407 |
6% |
15 |
18,804 |
9% |
11,445 |
|
700 |
407 |
6% |
17 |
21,311 |
9% |
12,504 |
Conclusions
By changing the expected earnings growth rate, the return
required by the investor and the assumed P/E ratio that will apply in ten years I can calculate
that today's TSX index should be anywhere from 8,862 to 14,700.
My own fair-value estimate is high-lighted in yellow and is
12,369. This assumes that investors require a
minimum 7% return, that the Toronto Stock Exchange
earnings and dividend will grow at 5.0% (3.0% GDP growth plus 2% inflation) and that the
long run TSX P/E is 15. My
projected P/E of 15 is based on the long run average of about 15.0 but is at the
higher end of he theoretical sustainable level of 12.5 to 15, noted above. Higher TSX
index values are implicitly assuming that earnings growth will exceed 5%
annually, that the justifiable long-run P/E exceeds 15, and/or that investors
require less than a 7% (pre-tax) return.
Since the Toronto Stock Exchange index is currently
about 9,065, I conclude that it may be about 27% under valued.
However considering that we may be entering a recession I
would also give weight to the first row of the table which indicates a fair
value for the TSX composite index of 10, 340 based on 4% earnings growth and a
terminal P/E of 13. This then indicates the index is 12% under valued.
Most investors would probably not admit to being happy with
a 7% return, but 6 to 8% is
still quite attractive compared to a recent 10 year Canadian government bond yield of about
3.8%.
My overall conclusion is that at its current level (as
of October 8, 2008) of
about 9,065 the Toronto Stock Exchange index
is probably at least 12% under valued and priced to return about 8% annually based on a ten
year holding period. The range around the estimated 8% average over
10-years is large and it could feasibly instead average 5% to 10% per year. In any given year
the return could certainly be negative.
It is impossible to predict where the Toronto Stock
Exchange index will go in the
next year. But it is relatively easy to calculate whether or not it is currently
over-valued based on reasonable growth expectations. Currently, the TSX index seems
under valued. Caution is warranted
because the TSX can sometimes spend years in an over-valued or an under-valued-state. But
ultimately, valuation does correct itself.
Readers should see also a similar
analysis of the S&P 500
index and the Dow Jones Industrial Average
Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend inc.
Updated October 11, 2008.
Note that my TSE 300 valuation
article on January 26, 2002 concluded that the Toronto stock index
was still over-valued at 7,659 even though it had fallen hard from its 2000 high
of 11,402. The Index subsequently fell below 6,000 later in 2002, before recovering
as earnings improved. As of October 11, 2008, an investment in the TSX composite
back io January 26, 2002 would have earned an average (but extremely lumpy) approximate
5.0% per year (2.6% for capital gains and roughly 2.4% for dividends). In effect the TSX
has now done worse than expected since early 2002. Earnings grew by an average
14% per year instead of the expected 7%. In retrospect this was likely because
the earnings in 2002 were abnormally low due to write-offs at that time. The P/E
at 28 in 2002 was then expected to go to 18 in the long run but has fallen all
the way to 13. www.investorsfriend.com
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