Rudi’s View: Plenty Of Traps In Equity Valuations

Rudi's View | Sep 18 2024

In this week's Weekly Insights:

-Plenty Of Traps In Equity Valuations
-Post-August Key Picks
-FNArena Talks
-Gen.Ai - A New Section On The Website

By Rudi Filapek-Vandyck, Editor

Plenty Of Traps In Equity Valuations

Financial markets operate in a constant flux because of changes in geopolitics, monetary policy, societal progression and technological innovation. As investors, it's probably best we keep a watchful eye out for any lasting changes, lest we be guided by the past rather than the future.

One of such changes that has not yet received enough attention is the fact the local share market has become noticeably more 'expensive' throughout the post-GFC years.

As was highlighted in a report by Morgan Stanley last week, the long-term average PE ratio for the ASX200 is now 14.7x, which is higher than the 14.4x that once served as the multi-decade average stretching back to the early nineties, but the average for the past decade sits at 15.9x.

That increase of almost 1.5x has happened without mining and energy being sustainably upgraded, which tells us a lot about a share market wherein these sectors represent some 30% of the index.

The observed increase in the average market multiple is partially attributable to changes in the composition and weightings of the index itself. CSL ((CSL)), which constantly trades on above-average multiples, is now the third largest constituent, while the likes of WiseTech Global ((WTC)), Block ((SQ2)), Pro Medicus ((PME)), Hub24 ((HUB)), REA Group ((REA)) and Car Group ((CAR)) have gradually climbed up the local ranks.

But it's not just that. The number two in the index today, CommBank ((CBA)), is trading on 24x times FY25 earnings per share, which is quite unprecedented for such a large bank on, equally important, rather small forecast increases in EPS and DPS for the two years ahead.

The latter is illustrated by the fact the PE multiple for CommBank is only falling to 23.3x on FY26 forecasts, with the forward-looking dividend yield only increasing to 3.4% from 3.3% in FY25, ex-franking.

The average PE multiple for the ASX100 in 2024 has blown out to 17.3x, making some investors nervous and triggering the conclusion from Morgan Stanley that local share prices have disconnected from underlying earnings growth.

Outside of the 1990s dot com boom and the covid-impact four years ago, the local market usually doesn't trade on such an elevated multiple. But then neither do CBA shares and, given CBA is the local number two, it's difficult to argue there's not a close correlation between the two.

Trading above $142 on Monday, CBA shares are displaying a 30% premium vis a vis the consensus price target as calculated from six leading stockbrokers monitored daily by FNArena. That's a pretty big number by anyone's standards.

Banks, including CBA, were among the positive surprises throughout the August results season locally, but any 'beats' delivered look rather small when compared with the numbers mentioned. Both National Australia Bank ((NAB)) and Westpac ((WBC)) shares are nowadays enjoying a multiple of around 17x, which previously had been the ceiling for premium CBA.

ANZ Bank ((ANZ)) is today's sector laggard trading on 14.2x times FY26 forecast EPS, which is lower than this year's estimate, which also explains the lower premium priced-in. The fact ANZ's risk profile includes more exposure to falling interest rates in Asia and to a significantly weaker economy in New Zealand doesn't by default imply the shares are of better 'value' than its peers.

Following what seems to have been a one-off 20% lift in dividend payout in FY23, ANZ's dividend is forecast to slide yet again, and stabilise in FY25 rather than rise. Already, ANZ Bank's dividends are no longer 100% franked.

The numbers cited will keep the public debate alive whether Australian banks are appropriately priced or egregiously expensive, and about the outlook for the share market generally.

All of this also highlights the dangers of relying on generalised PE ratios alone to make investment decisions and assess whether the stock market is too expensive or attractive.

When it comes to individual companies, those widely used PE multiples can be just as tricky, if only because it's so easy to make mistakes. Time to zoom in on the most commonly made errors, and why they are faulty.

Backward-looking reference points

Backward-looking data and multiples can have a function, within the right context and predominantly for share markets, as markets don't tend to grow as fast as individual companies.

But anyone trying to find an entry point on reasonable looking multiples for a fast growing Nvidia in the US, or Goodman Group ((GMG)), Hub24 ((HUB)) or WiseTech Global ((WTC)) closer to home, would have found it impossible on the basis of data and multiples from the past.

I cannot think of any better example as to why investors need to keep focusing on what likely lays ahead. Markets are constantly forward-looking, even if they are imperfect, as are those analysts' assumptions and projections that guide share prices (most of times).

Forecasts and multiples are not a static indicator

Probably the most often made mistake is to treat today's multiples as if they are set in stone. On-the-ground conditions are dynamic, which means things can change, in either direction, and turn today's set-up into a false or misleading proposition.

One such positive example is provided by Goodman Group, for whom consensus forecasts have steadily grown since the release of FY23 financials twelve months ago. Anyone who sold out because the multiple might have looked unattractive at that time has missed out on one of the most profitable opportunities the local bourse has offered over that period.

Goodman Group shares have appreciated from circa $20 in September 2023 to circa $36 today.

One prominently negative experience has been provided by Platinum Asset Management ((PTM)) for whom key financial metrics have continued to decline over the years past. This has reshaped this often 'cheap' looking proposition into a nasty value trap which will only turn around successfully if those key financials can be sustainably reversed onto a positive trajectory.

Shares in the local fund manager were trading around $5 only 3.5 years ago, they are below $1 in 2024. Analysts are yet to be convinced FY26 won't be another down-year.