27 NOV


Opinions , Tristan Abet

Equity valuation : growth premium vs systemic risk

No matter how much is said about financial asset valuation, the topic is still shrouded in mystery. Nothing surprising about that: there are no rules or stable models, as an asset’s price, as always, is decided by the seller and the purchaser. It’s purely subjective; even so, man just cannot help doing the math to find pseudo-rules and reasons for pricing on financial markets.

In the case of equities, the ground model is one borrowed from the bond world: by keeping the coupon rate, but replacing interest by dividend, the time horizon becomes infinite. The result is known, a geometric sequence with a common ratio 1+g (the dividend growth), as represented by the following:

This is the Gordon Shapiro model, where D is the initial dividend and k the discount rate.
Replacing D by the payout of earnings gives us the following equation:

The P/E will therefore depend on the discount rate – and thus on a preference – and on an expected growth rate.

That was our starting point for breaking down the equity P/E in accordance with two parameters: 1) the growth premium and 2) the remainder, i.e., the incompressible valuation of the equities, the P/E of companies with no growth.

Purists will cry wolf, as our chosen methodology involves simply applying linear P/E regression to the expected growth. They’ll be right, but we’re sticking to our guns as the results are easier to interpret and understand.
The equation : 
We apply it to the current universe (retropolation) of the Eurostoxx, the Nikkei, the emerging markets and, in the case of the US, to both the Nasdaq and the S&P 500 ex-Telecoms and Technology (SPxTT). Regression frequency is monthly and the data are as of May 2005 for all indices save the Nasdaq (2010). Here below is the record of the β, i.e., of the growth premiums (trailing P/E regressed on the prospective profit growth).

The growth premium fluctuates by around 0.4, meaning that a company with 10 growth points more than another company will have a P/E of over 4 points. As interesting as the graph above is, let us now focus on Europe by displaying only the European series.

The result is as expected: the premium is down between 2005 and 2008, remains low between 2008 and 2013 (double dip in Europe) then rebounds substantially to hit a high late last year, three months before the European PMI reversal. We can also see that the premium was unable, during this cycle, to retrieve its record high of mid-2005. Finally, with the latest figures dating from the end of October 2018, we can see that, although the recent growth premium decline was quite severe, it had not sunk to crisis levels (2008-2013).

The graph above shows the intercept of the regression, the incompressible P/E, the P/E when growth is null (the alpha of the equation). Here, we are alluding to the equity-related systemic risk premium, i.e., the valuation of equities independently of the expected growth profile. In this cycle, we can see a lower dispersion than during the previous cycle, with, more recently, two groups standing out: US and European equities, on the one hand, with their high multiple (15/16) and, on the other, EMs and Japan, which have a lower multiple (12/13).

From a purely equity-risk point of view, this cycle has been exceptional for the transatlantic universe, with the median incompressible P/E spiking to new record highs. This is important: before 2008/2009, the global P/E was high, as the growth premium was high. In this cycle, due to the higher systemic P/E, the US and European universes once again recorded high P/Es but without the growth premium reaching its previous levels. Highlighting only Europe again, this double dynamic is glaringly obvious.

We can see clear differences pre-2008 and post-2008. Before 2008, European equities registered a growth premium in the order of 0.4 and systemic P/E of 14/15. Last year, the growth premium was closer to 0.35 while systemic P/E was at 16/17.

Is such structural re-rating justified? This we don’t know, but if our diagnosis is correct, there can only be one conclusion: European equities remain intrinsically “expensive”. Even if they registered a low growth premium following the October correction, the European incompressible P/E re-rating was so strong as to invalidate any argument of a valuation beneficial to European equities.

Below, you see the statistics as at the end of October 2018 for the universes we follow. Conclusions? First of all, expected earnings growth for the next 12 months is stronger for the emerging universe and for the Nasdaq universe, while quite low for Japan. Europe and the US have similar estimates.

Prospective earnings growth, growth premium and incompressible P/E

Median data as at 31 October 2018

Secondly, the growth premium is strong for the Nasdaq and weak for Europe and the US ex-Nasdaq. For EMs, the growth premium is higher than Europe’s but a lot lower than the Nasdaq’s, even though estimated growth rates are very similar. This typically reflects a higher risk premium for EMs on the assumption that this higher growth is not sustainable and therefore particularly risky.

Thirdly, the incompressible P/E of Europe and of the US is much higher than that of the EMs and Japan. As this systemic valuation represents a structural risk premium, it is a key part of the debate concerning the relative valuation of Europe versus the US and confirms what we have known all along: European equities and US equities are on an equal footing. Nonetheless, by selecting the Eurostoxx 50 as a proxy of the European equity universe, we are strongly distorting the analysis as this index has been contaminated by low-growth and high-risk values.

Also, for the sake of discussion, these data are reminders of how fragile the assumption of rational expectations is, as we find ourselves confronted with a regime of adaptive or even extrapolative expectations. Indeed, the growth premium looks pro-cyclical whereas in "theory" it should go down when growth is strong and up when growth is weak.

In short, the message here is of a dual nature:

1)       As usual, valuation is not helpful and conveys quite a neutral message. Currently, all zones studied give cause neither for joy nor concern. Those in search of the psychological support afforded by low valuation may find a comfort zone in Japan.

2)       Unlike deductions that could be made from observing equity indices such as the S&P 500 or the Eurostoxx, it would appear that, for a year now – since 4Q 2017, to be precise – global equities have been substantially de-rated, as a result both of the growth premium decline (in anticipation of the cycle coming to an end?) and of a drop in the systemic P/E.

This second point is the most important. The change of paradigm dates not from February or October, but goes back to 4Q 2017. Once again – as in 2000 or 2007 – the reversal occurred endogenously, which begs the question: what can be done to end this de-rating phenomenon? We have our ideas on the matter … but, for the time being, we’re keeping mum !

The comments and opinions expressed in this article are those of the authors and not necessarily those of Candriam.