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.

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