In this QB, we’ll draw on the work that Martin Crabb of Shaw & Partners (Shaw’s) periodically produces to analyse equity valuations using informative charts. In the first chart, we observe a “fair value” black line, which charts the level that represents where the ASX 100 index ought to be trading – as modelled by Shaw’s, an orange line (where the market is trading), and a grey line (representing the level at which an investor can expect a 15% Total Shareholder Return or TSR). The chart indicates that the market is trading at fair value, thus there may be limited prospects according to the model of a 15% return. Ideally, you want to buy the market when the orange line is below the grey line (the market is cheap) and be more cautious when the orange line is above the black line (the market is expensive).
Source: Shaw & Partners
The next chart shows the market’s forward Price Earnings ratio (fPE). Over the long term – say over 25 years, the Australian market has tended to trade on a fPE of around 14.5x. Over the last 10 years or so, the market has traded at a slightly higher level of around 15.5x, probably reflecting in part the very low interest rates over most of that period. At present, the fPE of the market is at 18.7x, somewhat expensive compared to historical patterns. Of course, it should be noted that the fPE is looking at next year’s forecast earnings – those forecasts could be wrong, or indeed the market might be looking beyond next year and seeing value further down the track and be prepared to pay up for those better prospects. Unfortunately, the consensus outlook for strong earnings growth is largely absent from the Australian market at present.
Source: Shaw & Partners
Indeed, in the next chart, we see that the earnings growth of the Australian market has been disappointing, falling behind both the World (ex-US) and way behind the US, which is the global outperformer. Australia’s share market is of course heavily dominated by resources and the big banks and lacks globally competitive technology companies – the sector which has performed so well over the past few years.
Source: Shaw & Partners
Stripping out the banks and materials sectors, the picture improves somewhat. Nevertheless, our view is that the market is looking a little toppy, particularly given the lackluster earnings growth outlook, a sluggish domestic economy, and interest rates which are expected to stay at fairly high levels for some time given persistent inflationary pressures.
Source: Shaw & Partners
