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.