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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. www.investorsfriend.com
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