With the NZ Equity market hitting new recent highs and coming close to its all time high, it is only natural for commentators and participants to focus on valuation. While the Price/Earnings ratio is the often discussed measure of valuation, the ratio over simplifies valuation and does not take into account all the contributing factors.
The one year forward Price/Earnings multiple of the NZ market is currently around 15.5 times compared to its long run average over the last ten years of 14.7 times. It is simple to conclude that NZ equities are therefore over valued versus their long term average, but such simple analysis does not take into account where we are in the economic cycle and whether the earnings estimates used in the calculation are appropriate.
The last few years has seen a stabilization in company earnings but certainly not a recovery to strong growth, analysts have therefore become over cautious and we believe that earnings are likely to exceed expectations over the next year as the economic recovery continues and gains pace. Should this prove to be correct then the 1yr real forward Price/Earnings ratio is likely to be somewhat less than 15.5 times currently estimated.
Equity markets tend to respond to improved prospects before the improvement becomes evident and thus during a recovery companies tend to look more expensive than they actually are.
Analyzing another valuation metric would suggest the NZ equity market is currently fair value on a dividend yield basis, with the current prospective dividend yield equal to its 20 year average. Comparing the equity market dividend yield to current Government bond yields would suggest the NZ equity market is cheap. Other valuation metrics such as the equity risk premium and discounted cash flow analysis would also suggest the NZ equity market remains attractive.
The current investment climate of low interest rates, low but stable growth and most valuation metrics showing no signs of frothiness argues well for continued gains as earnings improve and the Price/Earnings multiple expands to reflect the current environment.