IS THE TORONTO COMPOSITE S&P/TSX INDEX (TSX index) FAIRLY VALUED AT THIS TIME?

This article draws on the teachings of Warren Buffett¹

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 which 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, commodities and financials and therefore it is not as easy to predict as would be a more fully diversified market index).

 

 

As of  September 28, 2011, the Toronto Stock Exchange  index was at 11,585 and had a Price Earnings Ratio ("P/E") of 14.7 based on trailing earnings and a Dividend yield of 2.91%. Source:

http://www.tmxmoney.com/HttpController?GetPage=EquityIndices&Language=en&Exchange=T&SelectedTab=
QuoteResults&IndexID=0000&OpenIndex=

This P/E is about equal to the historical average. Therefore the quick indication is that the S&P/TSX index is fairly valued at this time at 11,585. However this might be jumping to conclusions. We need to consider whether or not the earnings on the S&P/TSX index are representative of "normal" economic conditions.

Based on its reported index value and P/E the earnings on the Toronto stock exchange in the last year (based on the latest available quarterly reports) were $786. 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 $786 appears, based on the table below, to represent a recovery from the recession and is not quite as high as the levels reached in 2008. It appears to be a reasonably normalized level of earnings. 

For Comparison here are S&P/TSX  data reported in prior years:	Trailing Earnings	Historical P/E
September 28, 2011	$786	14.7
March 11, 2011	$711	19.2
May 29, 2010	$594	19.7
Dec 21, 2009	$368	31.4
October 11, 2008	$812	11.2
Feb 10, 2008	$792	16.4
Sept 8, 2007	$766	17.8
Sept 9, 2006	$739	16.1
Dec 7 , 2005	$551	20.2
January 26, 2002	minus $	negative
June 8, 2001	$292	28.3

The Toronto Stock Exchange composite index represents a portfolio of about 240 companies. For each $11,585 (the index value)  purchased, the underlying companies in the portfolio, in the last year earned  $786 and currently pays a dividend of $11,585* 0.0291 = $337 per year. 

When we buy the TSX Composite index, we can therefore think of it as being an investment or "stock" that (as of September 28, 2011) costs $11,585 and currently earns $786 per year (adjusted trailing earnings) and pays a dividend of $337 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of 11,585.

We know that the Toronto Stock Exchange  index was at 11,585 on September 28, 2011. 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.

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 couple 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 or fair 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	TSX Fair P/E today	Return per Year Buying at 11,585
786	337	4%	13	15,125	7%	10,581	13.5	5.9%
786	337	4%	15	17,452	7%	11,763	15.0	7.2%
786	337	4%	17	19,779	7%	12,946	16.5	8.3%
786	337	4%	13	15,125	9%	9,016	11.5	5.9%
786	337	4%	15	17,452	9%	9,999	12.7	7.2%
786	337	4%	17	19,779	9%	10,982	14.0	8.3%
786	337	5%	13	16,644	7%	11,503	14.6	6.9%
786	337	5%	15	19,205	7%	12,805	16.3	8.2%
786	337	5%	17	21,765	7%	14,107	17.9	9.4%
786	337	5%	13	16,644	9%	9,790	12.5	6.9%
786	337	5%	15	19,205	9%	10,872	13.8	8.2%
786	337	5%	17	21,765	9%	11,953	15.2	9.4%
786	337	6%	13	18,299	7%	12,504	15.9	7.9%
786	337	6%	15	21,114	7%	13,935	17.7	9.2%
786	337	6%	17	23,929	7%	15,366	19.5	10.4%
786	337	6%	13	18,299	9%	10,629	13.5	7.9%
786	337	6%	15	21,114	9%	11,819	15.0	9.2%
786	337	6%	17	23,929	9%	13,008	16.5	10.4%

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 8,699  to 14,742.

My own fair-value estimate is the average of the two rows high-lighted in yellow and is 11,838. This assumes that investors require a minimum 8% return, that the Toronto Stock Exchange  earnings ($786 as of now) 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 8% (pre-tax) return.

Since the Toronto Stock Exchange index  is currently  about 11,585, I conclude that it appears to beabout fairly valued. (The point estimate is 2% under-valued).

Possibly I should focus on a lower required return of 7% which is still quite attractive compared to a recent 10 year Canadian government bond yield of under 4%. (In which case the under-valuation point estimate increases to 10% under-valued).

My overall conclusion is that at its current level (as of September 28, 2011) of about 11,585 the Toronto Stock Exchange index  is probably about fairly 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 11% per year. In any given year the return could certainly be negative.

 The volatile nature of the TSX earnings makes it very hard to judge the value of this index. 

It is impossible to predict where the Toronto Stock Exchange index  will go in the next year. But it is possible to calculate whether or not it is currently fairly-valued based on reasonable growth expectations and based on the assumption that we have a reasonable starting point for the earnings. Currently, the TSX index seems fairly valued. Caution is warranted in interpreting the numbers because the TSX  earnings are volatile and can sometimes spend years in an over-valued or an under-valued-state. But ultimately, valuation does correct itself.

You can easily invest in the Toronto Stock Exchange index index by buying the ishares S&P/TSX Capped Composite Index under the symbol XIC on the Toronto Stock Exchange. There is also an index of the largest 60 shares in the Toronto Index, the ishares S&P/TSX 60 Index Fund trading under symbol XIU. And if you are really bullish you can buy the double bull as Horizons BetaPro S&P/TSX 60 Bull under symbol HXU. Or, if you are bearish, there is the single bear ETF Horizons BetaPro S&P/TSX 60 Inverse under symbol HIX, or the double bear Horizons BetaPro S&P/TSX 60 Bear under symbol HXD. Be cautious and understand what you are buying.

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 September 28, 2011. (ETF symbols added November 23, 2011)

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 September 28, 2011, an investment in the TSX composite back in January 26, 2002 would have earned an average (but extremely lumpy) approximate  5.5% per year (3.1% per year for capital gains and roughly 2.4% for dividends). In effect, it appears we correct that it was over-valued, since from that point until today the return was less than adequate. 

Here are past results from this analysis from our records:

Date of prior calculations	TSXS&P Level at that Date	Fair Value we Calculated		Average Capital Gain Per Year	Apparent Performance as of September 28, 2011 with the Index at 10,585 (and note that this was meant to be a long-term tool not short-term)
11-Mar-11	13,674	11,369	over-valued	-37.2% Note this large drop is annualized	In the early going. It appears we were correct that the TSX was over-valued.
29-May-10	11,671	11,637	about fair-valued	-7.1%	It appears we were wrong, our fair value was too high
21-Dec-09	11,555	11,565	about fair-valued	-4.8%	It appears we were wrong, our fair value was too high
11-Nov-08	9,065	12,369	under-valued	5.5%	It appears we were correct, late 2008 was a good time to invest in the TSX
10-Feb-08	12,989	13,027	about fair-valued	-5.5%	It appears we were wrong, our fair value was too high
8-Sep-07	13,651	12,585	over-valued	-6.1%	It appears we were correct it was over-valued, but the over-valuation was much worse than we calculated
9-Sep-06	11,870	12,476	about fair-valued	-2.2%	It appears we were wrong, our fair value was too high
7-Dec-05	11,131	10,261	over-valued	-0.9%	It appears we were correct, but the over-valuation was much worse than we calculated
26-Jan-02	7,659	5,986	over-valued	3.4%	It appears we were correct since an inadequate capital gain per year has resulted
6-Jul-01	7,594	6,014	over-valued	3.3%	It appears we were correct since an inadequate capital gain per year has resulted

 

 

1. See Warren Buffett in Fortune Magazine, November 22, 1999, and  his updated article of December 10, 2001.