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

This short article (which draws on Warren Buffett's teachings1) provides:

  1. Calculations of the current  fair value of the Toronto TSX stock exchange index based on several scenarios

  2. The Expected next 10-year average Return per Year from the Toronto TSX stock exchange based on earnings growth and terminal P/E Assumptions.

  3. The Toronto TSX stock exchange index P/E ratio

  4. Earnings and earnings yield on the Toronto TSX stock exchange index 

  5. Dividend Yield on the Toronto TSX stock exchange index

  6. The Exchange Traded Fund (ETF) symbols to use to invest in this Toronto TSX stock exchange index

This article concludes that:

A fair level of the Toronto Stock exchange index, based on its adjusted trailing earnings level, is about 14,226. You can compare that to its current level.  

At its  June 3, 2014 level of 14,735 the Toronto Stock Exchange index  was probably fairly valued and priced to return about 7% annually based on a ten year holding period.  The range around the estimated 7% average over 10-years is large and it could feasibly instead average  4% to 10% per year. In any given year the return could certainly be negative. In fact, it can be expected to be negative in some years.

This conclusion is heavily dependent on assuming that the adjusted trailing earnings figure for the index provided by ishares is correct.

Calculating a Fair Level of the Toronto Stock Index

The question of the fair value of the Toronto TSX stock exchange index can be explored mathematically by looking at the current consolidated total 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  June 3, 2014, the Toronto Stock Exchange  index was at 14,735 and had a Price Earnings Ratio ("P/E") of 38.6 based on trailing earnings and a Dividend yield of 2.84%.  This data was obtained by purchasing it from the TMX Group. 

This P/E is well above the historical average. Therefore the quick indication is that the S&P/TSX index is over valued at this time at 14,735. However this would 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 $382. 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. This $382 appears, based on the table below, to represent well below trend level earnings. It is likely due to large unusual losses at a few large companies. It is difficult to know what the normalized or adjusted level of earnings would be. 

ishares reports a trailing P/E ratio (which we understand they adjust for certain unusual losses) of 17.6. This would suggest that the trailing earnings were $837

We will use the iShares figure of $837. (It may be somewhat high due to the iShares adjustments)

 For Comparison here are S&P/TSX  data reported in prior years: Trailing Earnings  Historical P/E  Historical Earnings Yield
 June 3, 2014  $382  38.6  2.6%
 May 2, 2013  $658  19.1  5.3%
 March 17, 2012  $801  15.6  6.4%
 September, 28 2011  $786  14.7  6.8%
 March 11, 2011  $711  19.2  5.2%
 May 29, 2010  $594  19.7  5.1%
 Dec 21, 2009  $368  31.4  3.2%
 October 11, 2008  $812  11.2  8.9%
 Feb 10, 2008  $792  16.4  6.1%
  Sept 8, 2007  $766  17.8  5.6%
 Sept 9, 2006  $739  16.1  6.2%
 Dec 7 , 2005  $551  20.2  5.0%
 January 26, 2002 minus $  negative  negative
 June 8, 2001 $292  28.3  3.5%

The above table shows that the total reported earnings on the

The Toronto Stock Exchange composite index represents a portfolio of about 244 companies. For each $14,735 (the index value)  purchased, the underlying companies in the portfolio, in the last year earned  $837 (normalised trailing, according to ishares) and currently pays a dividend of $14,735* 0.0284 = $418 per year. 

When we buy the TSX Composite index, we can therefore think of it as being an investment or "stock" that (as of June 3, 2014) costs $14,735 and currently earns $837 per year (adjusted trailing earnings) and pays a dividend of $418 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of 14,735.

We know that the Toronto Stock Exchange  index was at 14,735 on June 3, 2014. 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 earn, on new investments,  the assumed 7 to 8% minimum ROEs required by investors even in a 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 second 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. The last column shows the return expected based on our assumptions.

 

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 Implied TSX Fair P/E today  Return per Year Buying at 14735 
         837          418 4% 13         16,107 6%     12,764            15.2 4.3%
         837          418 4% 15         18,584 6%     14,147            16.9 5.5%
         837          418 4% 17         21,062 6%     15,531            18.6 6.6%
         837          418 4% 13         16,107 8%     10,877            13.0 4.3%
         837          418 4% 15         18,584 8%     12,025            14.4 5.5%
         837          418 4% 17         21,062 8%     13,172            15.7 6.6%
         837          418 5% 13         17,724 6%     13,866            16.6 5.3%
         837          418 5% 15         20,451 6%     15,389            18.4 6.5%
         837          418 5% 17         23,178 6%     16,911            20.2 7.7%
         837          418 5% 13         17,724 8%     11,801            14.1 5.3%
         837          418 5% 15         20,451 8%     13,064            15.6 6.5%
         837          418 5% 17         23,178 8%     14,327            17.1 7.7%
         837          418 6% 13         19,486 6%     15,061            18.0 6.3%
         837          418 6% 15         22,484 6%     16,735            20.0 7.5%
         837          418 6% 17         25,482 6%     18,409            22.0 8.7%
         837          418 6% 13         19,486 8%     12,803            15.3 6.3%
         837          418 6% 15         22,484 8%     14,192            17.0 7.5%
         837          418 6% 17         25,482 8%     15,580            18.6 8.7%

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 10,877  to 18,409.

My own fair-value estimate is the average of the two rows high-lighted in yellow and is 14,226. This assumes that investors require a minimum 7% return, that the Toronto Stock Exchange  earnings (assumed to be $837 as of now) and dividend will grow at an average of 5.0%  per year for the next ten years (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 the 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 14,735, I conclude that it appears to be fairly valued. 

My required return of 7% is lower than historic equity returns but still very attractive compared today's 10 year Canadian government bond yield of just 2.3%. 

At that at its current level (as of June 3, 2014) of about 14,735 the Toronto Stock Exchange index  is probably fairly valued and priced to return about 7% annually based on a ten year holding period.  The range around the estimated 7% average over 10-years is large and it could feasibly instead average  4% to 10% per year. We should expect the return to be negative in some years.

 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.

ishares shows a price to book ratio of the TSX at 2.0. It is interesting to note that with the ishares P/E of 17.6 this implies a return on ending equity that averages 11.4%.

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 June 3, 2014. 

Here are past results from this analysis from our records:

 

 Date of prior calculations  TSX/S&P Level at that Date  Fair Value we Calculated  Valuation of TSX Average Capital Gain Per Year  Apparent Performance as of June 3, 2014 with the Index at 14,735 (and note that this was meant to be a long-term tool not short-term)
11-May-13         12,589                  12,630 about fair-valued 16.0% In the (very) early going. It appears we were too pessimistic.
17-Mar-12         12,497                  13,216 under-valued 7.7% In the (very) early going. It appears we were correct.
28-Sep-11         11,585                  11,838 about fair-valued 9.4% In the early going. It appears we were correct that the TSX was fairly valued (or perhaps it was somewhat under-valued).
11-Mar-11         13,674                  11,369 over-valued 2.3% In the early going. It appears we were correct.
29-May-10         11,671                  11,637 about fair-valued 6.0% It appears our fair value was about correct, the capital gain has been adequate, although barely so
21-Dec-09         11,555                  11,565 about fair-valued 5.6% It appears our fair value was about correct, the capital gain has been adequate, although barely so
11-Nov-08           9,065                  12,369 under-valued 9.1% It appears we were correct, the market was under-valued, a good investment
10-Feb-08         12,989                  13,027 about fair-valued 2.0% It appears we were wrong, our fair value was too high
8-Sep-07         13,651                  12,585 over-valued 1.1% It appears we were correct it was over-valued, but the overvaluation was much worse than we calculated
9-Sep-06         11,870                  12,476 about fair-valued 2.8% It appears we were wrong, our fair value was too high
7-Dec-05         11,131                  10,261 over-valued 3.4% It appears we were correct, but the over-valuation was worse than we calculated
26-Jan-02           7,659                    5,986 over-valued 5.4% It appears we were too pessimistic, actually the market was fairly valued, the capital gain has been adequate
6-Jul-01           7,594                    6,014 over-valued 5.3% It appears we were too pessimistic, actually the marker was fairly valued, the capital gain has been adequate

 

1. See Warren Buffett in Fortune Magazine, November 22, 1999, and  his updated article of December 10, 2001. The same linking of stock index growth to GDP (or GNP) was made in Buffett's October 9, 1969 letter to his partners.

 

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