IS THE TORONTO COMPOSITE S&P/TSX INDEX (TSX index) FAIRLY VALUED AT THIS TIME? (February 10, 2008)

This question can be answered 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. 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  February 10, 2008, the Toronto Stock Exchange  index was at 12,989and had a Price Earnings Ratio ("P/E") of 16.4 based on trailing earnings and a Dividend yield of 2.72%. (Source: http://www.tsx.ca/HttpController?GetPage=MDFIndicesView&SelectedTab=QuoteResults

&Exchange=T&IndexID=0000&OpenIndex=&Market=T&Language=en)

The Toronto Stock Exchange  represents a portfolio of about 280 stocks and Income Trusts. For each $12,989 (the index value)  purchased, the underlying companies in the portfolio, in the last year earned $12,989/16.4 = $792 and currently pay a dividend of $12,989* 0.0272 = $353 per year. 

When we Buy the TSX Composite index, we can therefore think of it as being an investment or "stock" that (as of February 10, 2008) costs $12,989 and currently earns $792 per year (actual trailing earnings) and pays a dividend of $353 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of 12,989.

We know that the Toronto Stock Exchange  index was at 12,989 on February 10, 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 16.6. (This is based on year-end data and excludes 1982 when the P/E went over 100 - 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	P/E forecast in 10 years	Resulting TSX Composite in 10 years	Required Return	TSX Composite Fair Value Today
792	353	4%	14	16,413	7%	11,375
792	353	4%	15	17,586	7%	11,971
792	353	4%	16	18,758	7%	12,567
792	353	4%	14	16,413	9%	9,687
792	353	4%	15	17,586	9%	10,182
792	353	4%	16	18,758	9%	10,677
792	353	5.0%	14	18,061	7%	12,371
792	353	5.0%	15	19,352	7%	13,027
792	353	5.0%	16	20,642	7%	13,683
792	353	5.0%	14	18,061	9%	10,522
792	353	5.0%	15	19,352	9%	11,067
792	353	5.0%	16	20,642	9%	11,612
792	353	6%	14	19,857	7%	13,451
792	353	6%	15	21,276	7%	14,172
792	353	6%	16	22,694	7%	14,893
792	353	6%	14	19,857	9%	11,428
792	353	6%	15	21,276	9%	12,027
792	353	6%	16	22,694	9%	12,626

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 9,687  to 14,893.

My own fair-value estimate is high-lighted in yellow and is 13,027. 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 gives weight to the long run average of 16.6 and gives weight to 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 12,989, I conclude that it is about fairly  valued.

The table illustrates quite a wide range for a reasonable fair value of the TSX .  Investors should be sobered by the fact that if investors require a 9% rate of return and if the earnings only grow at 5.0% (say 3.0% GDP plus 2% inflation) and if the TSX  commands a P/E of only 14 in ten years then the fair value of the TSX  today is calculated as only 10,522, which is 19% below the current value of 12,989! (And if we consider that today's TSX earnings may very well be at a cyclic peak, the picture gets even worse).

Most investors would probably not admit to being happy with a 7% return, but the level of the TSX suggests that investors have bid stocks up to the point where a realistic long-term return is probably no more than 6 to 8%. Also 6 to 8% is still quite attractive compared to a recent 10 year Canadian government bond yield of about 3.9%.  However the return should be higher than 7 to 8% if earnings growth is closer to 7 to 8% annually rather than my assumed 5.0%.

My overall conclusion is that at its current level (as of February 8, 2008) of about 12,989 the Toronto Stock Exchange index  is probably about fairly valued and priced to return about 7% annually based on a ten year holding period.  The range around the estimated 6% average over 10-years is large and it could feasibly instead average be 3% to 9% 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 fairly 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

In the short-term investors may wish to be cautious due to the probable recession in the U.S., the impact of the high Canadian dollar (will lower profits for many companies) and the risk that oil and other commodity prices will fall.

I would currently rate the TSX Index as somewhere around a Buy.

Shawn C. Allen, CFA, CMA, MBA, P.Eng.

President,  InvestorsFriend inc. 

Updated February 10, 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 September 2007, an investment in the TSX composite back in January 2002 would have earned an average (but very lumpy) approximate  11.2% per year (9.2% for capital gains and about 2% for dividends). In effect the TSX did much better than expected since early 2002 due to unexpectedly large earnings increases particularly by energy, resource and financial companies.

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