TSX Index Valuation


(This TSX valuation article is dated January 2002, for a current version, click here)

It’s amazing how little attention is paid to this very important question.

Most investors would probably conclude that the TSE 300 is not overvalued at its current level (recently 7659) since it is down 33% from its historic high of 11402 reached in early September of 2000.

Indeed, it seems quite clear that the TSE 300 is a better value at a recent 7659 then it was at its peak.

But is there a way to actually calculate if the TSE 300 represents good value at its current level?

Well, the TSE 300 index is calculated based on the share prices and market values of its 300 component companies. So, the TSE 300 can be thought of as a portfolio of stocks. So yes, it is possible to calculate the theoretical value of the earnings and dividends of the companies that make up the TSE 300.

There is a relatively simple way to model the value of a stock or portfolio.

It works by starting with the initial dividend and then forecasting the growth rate for (say) the next ten years. We then assume that the investor sells the shares at the end of ten years at an assumed P/E ratio. The value of the share or portfolio is then simply the present value of the dividends plus the present value of the proceeds from selling the shares.

Many analysts use this type of approach to calculate an intrinsic value for a given share. The tricky part is to forecast the growth rate in dividends and earnings and the likely P/E at which the shares will ultimately be sold.

The good news is that this approach is actually quite a bit easier to apply to a portfolio of stocks like the TSE 300 then it is to an individual stock. The reason is that the average growth rate on a broad portfolio of stocks and its likely future P/E ratio are both much more stable and predictable compared to individual stocks. This is because individual stocks are subject to a variety of unique and even random factors as they fight for success in the market. But a broad portfolio basically averages away most of the “noise” and so the portfolio is much more stable than individual stocks.

Strangely though, my experience is that you will seldom see this calculation made. The legendary investor, Benjamin Graham routinely made this type of calculation. That type of calculation may have fallen out of favour because in recent years the indexes continued to relentlessly advance even though they were probably fundamentally overvalued since perhaps the mid-nineties. After reading Graham’s work I was motivated to make this calculation. And with the recent collapse of the NASDAQ, it’s probably high time to revisit this type of calculation.

So, in order to calculate the value of the TSE 300, we need to know the starting point earnings and dividend.

The National Post indicates that on Friday January 25, 2002, the TSE 300 closed at 7659 and had a P/E of negative 42.3 and a dividend yield of 1.56%. This means that an investment of $8259 in the TSE 300 stocks had an underlying (trailing) earnings of 7659/(-42.3) = negative $181 per year and pays a dividend of 7659 * 0.0156 = $119 per year.

The negative P/E results from huge negative earnings by Nortel and other companies. This has to be considered an aberration. It’s hard to guess what the normalized earnings of the TSE are but it seems to me that the earnings are likely to recover to past levels. In order to approximate the adjusted or normalized earnings of the TSE I use the actual earnings that did occur in the past.

The National Post indicates that on Friday June 8, 2001 the TSE 300 closed at 8259 and had a P/E of 28.3. This means that an investment of $8259 in the TSE 300 stocks had an underlying earnings of 8259/28.3 =$292 per year at that time.

Using this historic earnings level, the adjusted P/E on the TSE at this time is 7659/292 = 26.2

The dividend is then $119/292 = 41% of earnings.

If you invested $7659 in the TSE 300 index for a period of ten years you would collect the dividend each year and then after ten years you could sell the index and realize a capital gain (or loss).

The dividends you would get would depend on the starting dividend of $119, and the growth rate in dividends.

The capital gain (or loss) would be determined by two factors. First is the earnings growth. If the average earnings of TSE 300 companies grows by 5% each year then the earnings will grow to $292 * (1.05) raised to the 10th power = $476. If we can sell the TSE 300 index at the same P/E (26.2) at which it was purchased then the TSE 300 index would be expected to be at $476 * 26.2 = 12471. In that case the capital gain for a $7659 investment would be $12471-$7659=$4812.

So far, so good, but now we must consider the other factor which is the P/E level that will actually apply in ten years. If the P/E level on the market falls back to a more historic average level of say 18, then the TSE 300 would be at only $476 * 18 = 8568 after ten years. This reduces our capital gain to just $8568 – $7659 = $909. Even with the dividends, this would not be a very good return for a ten year investment of $7659.

By assuming different growth rates and final P/E ratios it is a simple matter to calculate the value of the cash-flows that are expected from each $7659 invested in the index. The result would be a number that represents where you think the TSE 300 should be rather than where it is.

The following table provides this calculation and investors should study it carefully. The table is based on investing an initial amount of money equal to the current index. ($7659)

TSE 300 Current Annual Earnings TSE 300 Current Dividend Earnings and Dividend Growth P/E forecast in 10 years Resulting TSE 300 in 10 years Required Return TSE 300 Fair Value Today
296 119 7% 18 10,481 10% 5,066
296 119 7% 18 10,481 8% 5,986
296 119 5% 18 8,679 8% 5,042
296 119 10% 18 13,819 8% 7,719
296 119 10% 18 13,819 10% 6,518
296 119 10% 18 13,819 12% 5,529
296 119 15% 18 21,555 10% 9,842
296 119 7% 26 15,139 10% 6,862
296 119 7% 26 15,139 8% 8,143
296 119 5% 26 12,536 8% 6,829
296 119 10% 26 19,961 8% 10,564
296 119 10% 26 19,961 10% 8,886
296 119 10% 26 19,961 12% 7,506
296 119 15% 26 31,135 10% 13,536


By changing the expected earnings growth rate, the return required by the investor and the assumed P/E ratio in ten years I can calculate that today’s TSE 300 index should be anywhere from 5,000 to 13,500.

The actual value at which the TSE 300 index represents good value can be determined by considering a reasonable set of projections for the earnings growth, required return and future P/E ratio.

To set the expected average earnings growth rate we can start by assuming that the nominal (before inflation) Gross Domestic Product (“GDP”) may grow at around 5% (3% real growth plus 2% for inflation). And note that Warren Buffet in a December 1999 article in Forbes Magazine concluded that we should not expect corporate earnings to grow faster than GDP. A more optimistic GDP growth would be 7%.

So, a prudent estimate for average earnings growth is about 5% to 7%

Next we need to predict a reasonable P/E at which the TSE 300 index will be trading in ten years. The current P/E is about 26 but the average P/E on the DOW since 1950 is 18. Therefore I believe that a maximum future P/E of 18 should be assumed.

Finally, we need to assume a required rate of return. While we would all like to hope for 15% plus in the market, a realistic required return is probably 8% to 10%.

So, using 5% to 7% for growth, and 18 for a future P/E, will result in a TSE 300 index being at only 8679 to 10,481 in ten years time. I admit that that this sounds frightfully low but to get to a higher number requires that the average TSE 300 earnings will grow faster than the economy or that the P/E ratio will remain at a high level like 26 in ten years. If I require a 8% to 10% return, then I would need the TSE 300 to be at about 6000 or less today in order to consider it a safe investment. This assumes that the $292 that the TSE 300 was earning in June 2000 is a representative starting point. Today’s actual earnings on the TSE 300 are negative and cannot be used as a representative starting point.

The picture improves dramatically if I am willing to assume that the P/E will still be at 26 in ten years. In that case with an earnings growth of 5% or 7%, the TSE 300 index would be at 12,536 to 15,139 in ten years. That’s more like it and in this case if earnings grow at 5% and I want to earn 8% then I am willing to invest in the TSE 300 at 7217 or lower. But if I expect earnings to grow at 7% and I must earn 10%, then I can invest in the TSE 300 at 6829 or lower.

Since the TSE 300 is currently around 7700, I conclude that it is likely over-valued. Since I expect the P/E to be about 18 in ten years and earnings growth to be 5% to 7%, the table above indicates that the TSE should be about 5,000 to 6,000 today, in order to provide an expected return of 10% to 8%.

As investors we should be very concerned (alarmed?) that investing in the TSE 300 at today’s level is tantamount to betting that the average TSE 300 company will achieve a compounded earnings growth over 7%, or that the P/E ratio will remain at a level of 26 or more. Both of those seem like poor bets. The third possibility is that by investing in the TSE 300 index at today’s level, we are indicating our willingness to accept a return significantly less than 8%. This last seems the most likely scenario for today’s investor.

In summary, any way you look at it a TSE 300 index of about 7700 seems over-valued unless you are willing to bet that corporate earnings will grow significantly faster than 7% and/or that investor optimism will continue to support a P/E of 26 or higher and/or that you are willing to accept an expected return of less than 8%.

BUT, I hasten to point out that the TSE 300 has almost certainly been over-valued for a number of years now. Still, investors did quite well (until recently) because the P/E rather than regressing back to say 18, in fact continued to rise until the pull-back that began about 15 months ago. More recently the TSE P/E ratio actually fell below zero. This was not because stock prices fell but rather was because the earnings became negative mostly due to some huge write-offs by the likes of Nortel.

Also note that the above calculations assume that the annual TSE trailing earnings of $292 for an investment equal to the index value in dollars, achieved in June 2001 is a representative starting point. The fact that the TSE trailing earnings are currently negative illustrates the difficulty of obtaining a representative measurement of TSE earnings. If the actual normalized TSE 300 earnings are above $296 at this time, then the analysis above may be too conservative.

Given that the TSE 300 appears to be significantly over-valued, a prudent investor should not have all of their money in the market at this time. While I certainly would not advocate abandoning the market, an investor should probably be under weight the equity market at this time and should have some funds invested in cash or fixed income.

One possible solution is to avoid investing in the TSE 300 index and instead to invest in individual stocks that are under-valued.

Shawn Allen
January 26, 2002