Plenty of traps in valuing equities

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 recent report by Morgan Stanley, 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 (ASX: CSL), which constantly trades on above-average multiples, is now the third largest constituent, while the likes of WiseTech Global (ASX: WTC), Block (ASX: SQ2), Pro Medicus (ASX: PME), Hub24 (ASX: HUB), REA Group (ASX: REA) and Car Group (ASX: CAR) have gradually climbed up the local ranks.

But it's not just that. The number two in the index today, Commonwealth Bank, 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 (ASX: CBA) 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 ASX 100 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 at the time of writing, 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 (ASX: NAB) and Westpac (ASX: WBC) shares are nowadays enjoying a multiple of around 17x, which previously had been the ceiling for premium CBA.

ANZ Bank (ASX: 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 that 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 (ASX: GMG), Hub24 or WiseTech Global closer to home, would have found it impossible on the basis of data and multiples from the past.

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

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 (ASX: 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 that 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 that FY26 won't be another down-year.

(Addendum: It has since emerged that Regal Partners (RPL) is interested in acquiring Platinum Asset Management).

Look for broader context

Every indicator needs context, and when it comes to assessing the valuation of an individual company it often pays off to look beyond the one year ahead to avoid being hoodwinked by one-off impacts.

Insignia Financial (ASX: IFL), for example, has had a terrible few years that saw this financial services provider report a huge loss for FY24. For the current financial year, its EPS is projected to improve by nearly 200%, but that tells us more about how bad the past has been. The current consensus forecast for FY26 sees EPS growing by no more than 2.1%.

That latter number explains why the P/E ratio sits no higher than 7x. Having been hit by disappointment too often, the market has grown ultra-sceptical about when management will/can successfully guide this troubled ship onto a more prosperous course once again.

On the other side of the ledger, once the market sees a robust multi-year growth story, shares in those companies will no longer look 'cheap' ever again, unless that trajectory loses visibility or comes unstuck. 

This principle applies to today's data centre beneficiaries, including NextDC (ASX: NXT) and Macquarie Technology Group (ASX: MAQ), but equally so to companies including REA Group, WiseTech Global, Pro Medicus, and others.

While such sustainable growth stories have continuously traded on multiples well above the market average, shareholder returns have equally been well above average. Within this context, the better strategy might be to use additional tools such as consensus price targets.

Shares in REA Group, for example, are currently trading on 47.5x times the FY25 forecast EPS and 40.2x times the FY26 forecast EPS --well above the earlier highlighted market averages-- but most analysts' price targets are suggesting double-digit percentage upside for the share price.

No one size fits all

The example of REA Group also highlights one extremely important feature of the share market; different valuation dynamics apply for different sectors and even for different companies inside the same sector. Simply applying Peter Lynch's rule of thumb as published in the 1990s seems but ill-informed in today's context.

As almost perfectly illustrated by the local banking sector over the past two decades, some companies enjoy a premium valuation, often linked to classifications of quality and market leadership, and avoiding them out of fear they might lose their premium appreciation often means missing out on the better opportunities.

CommBank shares have steadfastly traded on a premium versus the rest of the sector, and they have, by far, generated the superior return for shareholders. A common saying among investors is that sometimes a stock is 'cheap' for good reason. The experience for CommBank shareholders is that sometimes a stock looks 'expensive' for a very good reason, and that reason is linked to operational superiority and outsized returns.

Of course, once a company enjoys exceptionally quality status and a premium valuation, it needs to maintain that status or else lose the premium, with negative consequences. One good example is private hospital operator Ramsay Health Care (ASX: RHC), widely revered until 2016, but travelling through struggle street since.

The result is Ramsay's share price today is lower than where it was ten years ago. The privilege needs to be earned time and again.

Equally important: P/E ratios work the other way around for highly cyclical commodity stocks, i.e. BHP Group (ASX: BHP) shares trading on 80x times the forecast FY16 EPS in February of 2016 did not indicate the shares were 'expensive' as the signal might have suggested for a bank or a supermarket operator, but it indicated those shares were dirt cheap.

As many might remember, BHP shares sank briefly below $13 in those days. They have since revisited the $50 level.

That BHP experience also highlights a common mistake that is all too often made: a share price that is sold down after a major negative development does not by definition trade on a reduced P/E multiple. More often than not, the multiple will rise as investors anticipate a recovery on the horizon.

It is only when investors give up on such a prospect that a weak share price combines with a low P/E multiple, but this is one big red flag for investors, not a screaming buy signal.

Returning to the cyclicals, shares in BlueScope Steel (ASX: BSL) trading on no more than 3x times forward-looking EPS back in mid-2021 did not signal a 'cheap' and attractive proposition at hand. The shares subsequently weakened from $25 to $15 and as forecasts were cut too, the PE multiple doubled to 6x.

Today, BlueScope Steel's multiple is 15.5x and consensus price targets are suggesting a double-digit percentage upside is possible.

Also important: P/E ratios simply do not apply to large segments of the share market, including stocks that trade in close relationship with bond markets, also referred to as bond proxies. Exceptions include APA Group (ASX: APA) and Transurban (ASX: TCL), as well as just about every listed A-REIT.

There's a fair argument to be made that a company like Telstra (ASX: TLS) also should not be judged on its P/E multiple. Similar to APA and the REITs, it's all about yield, dividend sustainability, and relative attraction vis a vis the credit and bond markets.

One fairly modern methodology to value technology companies is the Rule of 40 which dictates revenue growth plus EBITDA margin needs to sum up to 40 or higher. This method too, including its multiple variants, doesn't always compare well with the old-fashioned PE multiple.

For those reasons, I tend to also pay attention to consensus price targets, interpreted in an intelligent manner, as well as trends in forecasts and the broader macro picture. The latter two factors can impact heavily on the outlook and the financial metrics of companies.

Underlying lives the understanding not everything can be forecast or anticipated. Plus too much risk will spoil the party at some point, even though that is not directly related to the P/E multiples in the portfolio.

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