The Sharemarket Myth of the “New Normal”

By Martin Fowler

Posted: 6th June 2012 09:13

With the Australian share market oscillating in a trading range of around 4,000 to 4,400 points for several years now, it is little wonder that investors are beginning to doubt old rules of thumb in favour of the concept of the "new normal".  One increasingly common example is the multiple of earnings or price to earnings ratio (PE).  The price to earnings ratio measures the number of years it takes for a company's earnings to reflect its share price.
 
Historically, the Australian share market has traded on an average PE multiple of around 14-15 times earnings since about 1970.  When viewed over shorter time frames, the PE ratio has varied significantly.  Typically in challenging market conditions the PE ratio will be much lower and in buoyant times, much higher.  When we look back at recent history, the market traded at around 8-12 times earnings during extended periods in the 1970's when stagflation was rife (high unemployment and high inflation).   Naturally earnings growth in such periods is more difficult to obtain.
 
In recent times an increasing number of investment commentators are suggesting that the long term PE average is no longer an appropriate rule of thumb.  Instead they argue that the future PE should be much lower, more around 11-12 times earnings.  In the short term of course this makes reasonable sense but over the long term, this is highly likely to be wrong.  Let me explain why.
 
Intrinsic Value
 
The intrinsic value of a share represents the present value of its future cash flows  It can be best understood by a simple example:
 
Example – Company XYZ
Earnings per share, Year 1: $1
Earnings per share, Year 2: $1.15
Earnings growth rate, Year 3 onwards: 3%p.a.
Weighted average cost of capital (WACC): 10%
 
Present Value of future earnings equals:
Yr 1: $1/(1.10) = $0.91
Plus Yr 2: $1.15/[(1.10)x (1.10) = $0.95
Plus Terminal value: [($1.15 x 1.03)/(0.10-0.03) ] x (1.10)-2= $13.98
Total (Intrinsic Valuation): $15.84
 
If the share price of Company XYZ was the same as its intrinsic valuation then the PE ratio would be 15.84. If the share price was, say $13, then the PE ratio would be 13. 

How Does The PE Ratio Then Provide A Guide To Future Growth?
 
The market (ASX 200 index) represents the “price” of the market as a whole.  In a perfect world, it also represents the present value of future earnings of the market as whole.  When this index is divided by current year earnings, the PE of the market can be derived. 
 
Example:
ASX 200 Index (price): 4200
ASX 200 WACC: 10%
Market earnings: 420
 
Therefore, PE multiple equals 10x
 
Using this information, the formula used to determine terminal cashflows can be rearranged to solve for (g) growth as follows:
 
Present value = Earnings / (WACC – Future Growth Rate)
4200 = 420 / (0.10-g)
Solving for g: (Future Growth Rate) = 0%
 
This means that when the weighted average cost of capital for the entire market is 10% and the PE of the market is 10, then the future growth priced into the market is effectively zero.  In other words, by investing when the PE of the market is at 10, you are effectively buying into a market that does not expect any future growth whatsoever.  It follows that if growth does arrive, then the market index will rise.
 
In the same way we can solve for (g) when we know the market PE multiple as follows:
 
                If PE = 14,
                then by deduction, Price = 14 and Earnings = 1
                Assume WACC= 10%
                Therefore;
                Present value = Earnings / (WACC – Future Growth Rate)
                14= 1/ (0.10-g)
                g = 2.9%
 
The amount of growth factored into the market at a given PE and WACC level can be summarised as follows:

                                   Implied Market Future Growth Rates-annualised
                           pe=10x  pe=11x   pe=12x pe=13x  pe=14x pe=15x pe=16x  pe=17x pe=18x
WACC,  9%          -0.7%  |  0.2%    | 1.0%  | 1.6%   | 2.2%   |  2.6%  | 3.1%   | 3.4%   | 3.7%   |
WACC, 10%          0.0%  |  0.9%    | 1.7%  |  2.3%  | 2.9%   |  3.3%  | 3.8%   | 4.1%   | 4.4%   |
WACC, 11%          1.0%  |  1.9%    | 2.7%  |  3.3%  | 3.9%   |  4.3%  | 4.8%   | 5.1%   | 5.4%   |
 
Outcomes
 
If we assume that that the long term WACC has approximated 10% over the period since 1970, then the outcomes are telling:
 
1) A PE of 14 implies a perpetual earnings growth rate of 2.9%p.a and a PE of 15 implies a perpetual growth rate of 3.3%p.a.  Economic growth in Australia has typically averaged around 3%– 3.5%p.a. over the long term since 1970.  You would expect real earnings growth on average to approximate GDP growth over the long run.  This dovetails nicely with observed data over the same period, where the market PE multiple averaged between 14 and 15 times earnings. 
 
2) Over the last 12 months the PE multiple for the ASX 200 has varied between 10 and 12.  A PE multiple of 10 implies zero future earnings growth and a PE of 12 implies only 1.7%p.a. earnings growth. 
 
Conclusions
 
Historically the market has traded on an earnings multiple of around 14-15 times earnings.  The global economic downturn has caused many pundits to revise their future expectation of what constitutes a valid future earnings multiple to a level of around 11-12 times earnings.  Simple mathematics, tell us that such a PE multiple actually implies a long term growth rate of between 0.9% - 1.7%.  This multiple is well below the long term trend rate of economic growth in Australia.  While the prospect of subdued growth over the next few years remains plausible, history shows that even the worst downturns are temporary.  Unless you subscribe to the view that economic growth will never recover, then an expectation of a permanently lower PE multiple is statistically improbable.  The pundits are more likely to be wrong than not. 
 
Notes
 
What is the PE ratio/multiple?
 
By way of example, a company that made $1 in earnings per share and has a share price of $10, is said to have a PE ratio of 10.  In other word, the company's share price equates to 10 years worth of current year earnings. 
 
The weighted average earnings for an entire share market also has a PE ratio calculated in the same way, except that the "price" of the market at any point in time is the index itself.  If the weighted average earnings of top 200 companies in the Australian sharemaket totals $400, and the share market index is trading at 4,400, the market is said to be trading on a multiple of 11 times earnings (PE of 11).
 
What is Present Value ?
 
Present value is a relatively straight forward concept.  If you were given the choice of receiving a $100 today or $100 in 5 years time, almost everyone would take the $100 today.  This is because the purchasing power of money erodes over time due to the impact of inflation.  Mathematically, if we assume a 3% rate of inflation per annum, then $100 in 5 years time is only worth $86 today.
 
What are Future Cashflows?
 
The second concept to understand is future cash flows.  A share is worth the sum of future cashflows discounted back to arrive at a present value.  Forecasting accuracy diminishes over time.  For this reason, analysts tend to use an average forecast rate of growth more than 3 years out, known as the terminal growth rate.
 
Future Cash Flows = Cf1+Cf2+ Cf3+....Cfn;
 
where Cfn = terminal cash-flow.
                 = Cf3/ (WACC – future earnings growth)
 
What is the Weighted Average Cost of Capital (WACC)?
 
The future earnings of a company are discounted back by a factor known as the weighted average cost of capital.  This represents the weighted average cost of debt  plus the weighted average cost of equity .  The cost of debt effectively represents the after tax interest payments to debtholders as a percentage of total debt.  The cost of equity effectively represents the required rate of return of investing in a similar investment with a similar risk profile.  Historically, the weighted average cost of capital of the market as whole is typically around 10% (+/- 2%). 

 
Martin Fowler is a director of Moore Stephens Sydney Wealth Management where he provides financial advice to high net wealth individuals and conducts research into the social impact of economic policy. He is also a director of Whitefield Limited, an investment company listed on the Australian Stock Exchange.
 
Martin can be contacted via email at 
Mjfowler@Moorestephens.Com.Au or alternatively by phoning +61 2 8236 7700.


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