Is the ASX over-priced?

On the weekend I discussed how earnings for the S&P 500 have grown by roughly 6.0% over the last three decades but the growth rate should rise as stock buybacks have averaged just over 3.0% a year since 2011. In an ideal world the growth rate would lift to close to 9.0% p.a. if buybacks continue at the present rate. Add a 2.0% dividend yield and we have an expected annual return close to 11.0%.

Forward Price Earnings Ratio for S&P 500

I conducted a similar exercise for the ASX using data supplied by marketindex.com.au.

The first noticeable difference is that earnings for the ASX All Ordinaries Index grew at a slower pace. Earnings since 1980 grew at an average compound annual growth rate of 4.4%, while dividends grew at a much higher rate of 6.3%.

Forward Price Earnings Ratio for S&P 500

How is that possible?

Well the dividend payout ratio increased from the low forties to the high seventies. An average of just over 60%.

With a current payout ratio of 77% (Feb 2017), there is little room to increase the payout ratio any further. I expect dividend growth to match earnings growth (4.4% p.a.) for the foreseeable future.

Buybacks are not a major feature on the ASX, where investors favor dividends because of the franking credits. The dividend yield is higher, at just over 4.0%, for the same reason.

So the expected average return on the All Ordinaries Index should be no higher than 8.4% p.a. (the sum of dividend yield and expected growth) compared to an expected return of close to 11.0% for the S&P 500. That is, if buybacks are effective in lifting the earnings growth rate.

Obviously one has to factor in expected changes in the (AUDUSD) exchange rate, but that is a substantial difference for offshore investors. Local investors are also taking into account franking credits which benefit could amount to an additional 1.4% p.a.. But that still leaves a grossed-up return just shy of 10 percent (9.8% p.a.).

I would have expected a larger risk premium for a smaller exchange with strong commodity exposure.

6 thoughts on “Is the ASX over-priced?

  1. Gordon says:

    So, to return to your headline, “Is the ASX overpriced?”.
    Well, IS it?

    • ColinTwiggs says:

      The All Ords offers a lower expected return (dividends plus expected earnings growth) than the S&P 500.

      I would normally argue that this is justified by the strong representation of banks (35% of the index total), with a relatively stable income stream compared to most other sectors, which more than compensates for the volatility of the resources sector (Materials are 15% of the index). But I no longer consider this justified because of the debt bubble, with household debt close to 185% of disposable income (some refer to this as a housing bubble but I prefer to focus on the underlying cause).

      Average House Price Growth

      Banks are also under-capitalized, with Tier 1 capital about 6% of unweighted credit exposure.

      So the short answer is YES.

  2. Richard says:

    “I would have expected a larger risk premium for a smaller exchange with strong commodity exposure.”
    So…. ummm, trying to work out the double or triple negative trip up there. Does that mean you would expect prices to be higher or lower ? or returns higher or lower ? or expected P/E to be higher or lower ?
    thanks,

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