# S&P/TSX Toronto Stock Index, Earnings and Valuation Analysis

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

This short article (which draws on Warren Buffett’s teachings^{1}) provides:

- Calculations of the
**current fair value of the Toronto TSX stock exchange**index based on several scenarios **The Expected**next 10-year**average Return per Year**from the**Toronto TSX stock exchange**based on earnings growth and terminal P/E**Assumptions**.**The Toronto TSX stock exchange index P/E ratio****Earnings and earnings yield on the Toronto TSX stock exchange index****Dividend Yield on the Toronto TSX stock exchange index****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 our estimate of its *normalized* trailing earnings level, is about 13,980. You can compare that to its current level.

However, the past earnings level of the TSX index has been extremely volatile. This makes it very difficult to estimate the trailing normalized earnings level. For that reason, there is a great deal of uncertainty in our estimate at this time.

At its November 29, 2016 level of 15,008, the Toronto Stock Exchange index was probably moderately over valued and priced to return about 5% annually based on a ten year holding period. The range around the estimated 5% average over 10 years is large and it could feasibly instead average 2% to 8% 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 our normalised adjusted trailing earnings figure for the index is correct. (Which, due to the nature of the TSX is a questionable assumption).

**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 (usually) 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 somewhat insulated from the numerous random events that can impact an individual stock. And, keep in mind that the TSX index is heavily concentrated in financials (35%), energy (21%), and materials (12%) and therefore it is not as easy to predict as would be a more fully diversified market index.

As of November 29, 2016, the Toronto Stock Exchange composite index was at 15,008 and had an ostensibly very unattractive Price Earnings Ratio (“P/E”) of 59 based on actual trailing earnings as reported by Statistics Canada. The P/E based on our normalized view of earnings was also unattractive 23. The dividend yield was 2.82%. We will focus on the adjusted or normalized P/E of 23. This P/E is somewhat above the historical average. Therefore, the quick indication is that the S&P/TSX index is moderately over-valued at this time at 15,008. Below, we provide further analysis.

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 just $255. 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. Unfortunately, based on the table below it is very difficult indeed to arrive at a representative earnings level. There is no apparent trend to the earnings. The ten year average level is $639. Allowing for some growth we will use $650. But this may be generous given the current $255 level and given lower oil prices.

**Historic S&P/TSX Figures:**

Year End |
Trailing Earnings $ |
P/E |
Earnings Yield % |

2015 | 366 | 35.5 | 2.8% |

2014 | 608 | 24.1 | 4.1 |

2013 | 443 | 30.8 | 3.2 |

2012 | 671 | 18.5 | 5.4 |

2011 | 839 | 14.2 | 7.0 |

2010 | 682 | 19.7 | 5.1 |

2009 | 377 | 31.1 | 3.2 |

2008 | 832 | 10.8 | 9.3 |

2007 | 751 | 18.4 | 5.4 |

2006 | 818 | 15.8 | 6.3 |

2005 | 565 | 19.9 | 5.0 |

2004 | 503 | 18.4 | 5.4 |

2003 | 417 | 19.7 | 5.1 |

2002 | 152 | 42.4 | 2.4 |

2001 | negative | n.a. | n.a. |

2000 | 388 | 23.0 | 4.3 |

The above P/E data is directly from Statistics Canada CANSIM Table 176-0047 and the earnings were calculated from the Statistics Canada data.

The above table shows that the total reported earnings on the the Toronto Stock Exchange composite index which represents a portfolio of 247 companies. For each $15,008 (the index value) purchased, the underlying companies in the portfolio, in the last year earned $650 (estimated normalised trailing level) and currently pays a dividend of $15,008* 0.0282 = $423 per year.

When we buy the TSX Composite index, we can therefore think of it as being an investment or “stock” that (as of November 29, 2016) cost $15,008 per share and currently earns $650 per year (estimated normalized trailing earnings) and pays a dividend of $423 per year. It is worth thinking about whether or not this “stock” is a good investment at or around its recent level of 15,008.

We know that the Toronto Stock Exchange index **was** at 15,008 on November 29, 2016, 2015. We can estimate what the TSX **“should”** have been trading at based on the value of its current (albeit estimated normalized) 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 3% to 5% and I would focus on 4%.

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/Ewent 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 about 14.3 to 16.7, with today’s low interest rates and a required return of 7%.** This conservative calculation of the justifiable P/E assumes that, on average, the TSX companies will earn, on new investments, the assumed 7% minimum ROEs required by investors (or for the higher end of the range will earn slightly more at 8%). If companies can sustainably earn significantly 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 fromten 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 |

650 | 423 | 3% | 13 | 11,356 | 6% | 9,966 |

650 | 423 | 3% | 15 | 13,103 | 6% | 10,941 |

650 | 423 | 3% | 17 | 14,850 | 6% | 11,917 |

650 | 423 | 3% | 13 | 11,356 | 7% | 9,224 |

650 | 423 | 3% | 15 | 13,103 | 7% | 10,112 |

650 | 423 | 3% | 17 | 14,850 | 7% | 11,000 |

650 | 423 | 6% | 13 | 15,133 | 6% | 12,680 |

650 | 423 | 6% | 15 | 17,461 | 6% | 13,980 |

650 | 423 | 6% | 17 | 19,789 | 6% | 15,280 |

650 | 423 | 6% | 13 | 15,133 | 7% | 11,711 |

650 | 423 | 6% | 15 | 17,461 | 7% | 12,895 |

650 | 423 | 6% | 17 | 19,789 | 7% | 14,078 |

650 | 423 | 9% | 13 | 20,004 | 6% | 16,118 |

650 | 423 | 9% | 15 | 23,082 | 6% | 17,836 |

650 | 423 | 9% | 17 | 26,159 | 6% | 19,555 |

650 | 423 | 9% | 13 | 20,004 | 7% | 14,859 |

650 | 423 | 9% | 15 | 23,082 | 7% | 16,424 |

650 | 423 | 9% | 17 | 26,159 | 7% | 17,988 |

**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 9,224 to 19,555.

My own fair-value estimate is from the row highlighted in yellow and is 13,980. This assumes that investors require a minimum 6.0% return, that the Toronto Stock Exchange earnings (estimated to be $650 as of now on a normalised basis) and dividend will grow at an average of 6.0% per year for the next ten years 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 and is consistent with the theoretical sustainable level of 14.3 to 16.7, noted above. Higher TSX index values are implicitly assuming that earnings growth will exceed 4% annually, that the justifiable long-run P/E exceeds 15, and/or that investors require less than a 6.5% (pre-tax) return.

Since the Toronto Stock Exchange index is at 15,008, as of November 29, 2016, I conclude that it appears to have been about 7% over-valued compared to my fair value estimate as of that date.

My required return of 6.0% is lower than historic equity returns but still very attractive compared today’s 10 year Canadian government bond yield of just 1.5%.

At its current level (as of November 29, 2016) of 15,008 the Toronto Stock Exchange index was probably moderately over valued and priced to return about 5% annually based on a ten year holding period. The range around the estimated 5% average over 10-years is large and it could feasibly instead average 2% to 8% per year. We should expect the return to be negative in some years.

However, the extremely 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 moderately under-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 November 29, 2016.

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 November 29, 20165 with the Index at 15,008 (and note that this was meant to be a long-term tool not short-term) |

17-Sep-15 | 13787 |
15139 |
under-valued |
7.3% | In the (very) early going. It appears we were correct. |

03-Jun-14 | 14735 |
14226 |
about fair-valued |
0.7% | In the (very) early going. It appears we were too optimistic. |

11-May-13 | 12,589 | 12,630 | about fair-valued |
5.1% | In the early going. It appears we were about correct. |

17-Mar-12 | 12,497 | 13,216 | under-valued |
4.0% | It appears we were too optimistic. |

28-Sep-11 | 11,585 | 11,838 | about fair-valued |
5.1% | It appears we were correct that the TSX was fairly valued. |

11-Mar-11 | 13,674 | 11,369 | over-valued |
1.6% | It appears we were correct |

29-May-10 | 11,671 | 11,637 | about fair-valued |
3.9% | 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 |
3.8% | 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 |
6.5% | It appears we were correct, the market was under-valued, a good investment |

10-Feb-08 | 12,989 | 13,027 | about fair-valued |
1.7% | It appears we were wrong, our fair value was too high |

08-Sep-07 | 13,651 | 12,585 | over-valued |
1.0% | It appears we were correct it was over-valued, but the overvaluation was much worse than we calculated |

09-Sep-06 | 11,870 | 12,476 | about fair-valued |
2.3% | It appears we were wrong, our fair value was too high |

07-Dec-05 | 11,131 | 10,261 | over-valued |
2.8% | It appears we were correct, but the over-valuation was worse than we calculated |

26-Jan-02 | 7,659 | 5,986 | over-valued |
4.6% | It appears we were correct in that the capital gain has been less than investors would have “required” at that time. |

06-Jul-01 | 7,594 | 6,014 | over-valued |
4.5% | It appears we were correct in that the capital gain has been less than investors would have “required” at that time. |

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.