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Morningstar | ASX Remains Overvalued and at the Whim of Interest Rates

Wide-moat-rated ASX Limited’s share price continues to shoot higher and is up 55% over the past two years. However, we attribute share price growth more to falling interest rates than a material improvement in ASX’s earnings growth outlook. Over the past decade, ASX has generated an EPS CAGR of just 1.9% and we forecast an EPS CAGR of only 4.4% over the next decade. The combination of a rising share price and largely unchanged EPS forecasts has been an expansion in ASX’s one-year forward price/earnings ratio from 23 to 33 or, looked at another way, the EPS yield has contracted from 4.3% to 3.0%. However, at the current share price, we think investors are settling for investment returns which are too low, and we continue to believe the stock is materially overvalued relative to our AUD 52.00 fair value estimate.

Plummeting interest rates are creating a challenging investment environment for Australian investors. Over the past two years alone, the Australian 10-year government bond yield, widely regarded as the "risk-free" investment rate, has collapsed from 2.6% to a record low of 1.3%. The long-term "risk-free" rate is important because it is the starting point for valuing most income producing assets. Investors should require a higher rate of return from equities than the "risk-free" rate because the income generated by equities has greater uncertainty.

Determining a "fair" return from equities is subjective and requires analysis of realised and likely future returns. The Reserve Bank of Australia recently showed that the average annual total return from Australian equities over the past 100 years was 12% and that the equity risk premium was around 6%. This means investors have historically required a 6% annual return, over the risk-free rate, as compensation for accepting the added risk of investing in equities. Buying equities with a sub-6% risk premium could therefore result in a loss if the market subsequently reverts to long-term averages.

The current low interest rate environment and associated equity yield compression is challenging because it’s unclear if investors are irrationally accepting a lower equity risk premium or if they are correctly predicting a sustainably lower risk-free rate. Going forward, the long-term gradual slowing of economic growth suggests historical average total returns and interest rates are unlikely to be maintained. Morningstar’s methodology therefore assumes a "fair" total return from equities of 9.0%, based on both an expected long-term risk-free rate and equity risk premium of 4.5%.

Our risk-free rate assumption is arguably our biggest call currently with regards to our total return assumption for equities. However, it’s worth bearing in mind that, not only is this rate close to the long-term historical risk-free rate, but also that the Reserve Bank of Australia has an inflation target of between 2% and 3%. This is important because some economists believe that the risk-free rate will be similar to nominal GDP growth rate. Considering long term real GDP growth is around 2.5%, this implies nominal GDP growth, and potentially a risk-free rate, of around 4.5%.

If our ASX earnings forecasts are correct, we estimate that the current ASX share price of AUD 80 implies investors are accepting a total return of just 5.5% from the stock. If the risk-free rate reverts closer to its long-term average, and our 4.5% assumption, then the current ASX Limited share price implies investors are accepting an equity risk premium of just 1%, which we expect to result in and inadequate risk adjusted return.

Although we don’t believe ASX’s earnings growth outlook has improved, it’s possible that ASX’s P/E expansion simply reflects an improvement in investors earnings growth expectations. If true, this would likely relate to the distributed ledger technology project to replace the Clearing House Electronic Subregister System, or CHESS. It could also relate to ASX’s project with Sympli to build an electronic real estate settlements system. However, we think both projects are too immature to justify increasing earnings forecasts at this stage. ASX is also hoping to become an important listing destination for overseas technology stocks, but the number of listed entities is not growing materially currently meaning there’s little evidence of this strategy significantly boosting earnings growth.