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Is the JSE really that expensive?

May 31 2018 12:22
Schalk Louw

No one on earth likes to pay for something when it is considered “expensive”. I always say that my favourite word is “free”, followed by “cheap”. Unfortunately, we all know that freebies are extremely rare, and that finding cheapies more often than not requires a lot of patience. The fact, however, is that cheapness is a relative concept, and the outcome will depend on the approach you take to determine it.  

It may sound like a strange statement, because many would argue that something cheap definitely cannot be confused with something expensive. Well, I realised the true value of this statement last year during a European vacation.

If I told you as a South African that you would have to pay R30 if you would like to buy a two-litre Coke from me, you would think I’m crazy, because you would pay around R17 for the exact same thing at any small retailer. The typical European, however, who would easily have to cough up €3 for the same soft drink in Europe, would consider R30 a bargain, and R17 as a giveaway! This means that we first have to measure an item’s “cheapness” or “expensiveness” in order to place it in context. 

When we consider investing in the local stock market now, we are warned by many experts to exercise caution, because the market may lean towards the more expensive side. I also discussed this in a recent article (see goo.gl/wZ7Nre). The moment we start to discuss how expensive the market is, the JSE’s historical price-to-earnings ratio (P/E) is mentioned. The P/E shows us the company’s share price relative to its earnings (profit), ultimately telling us how cheap or expensive a particular company’s share is. When the P/E drops, the company becomes “cheaper”.

When experts refer to the JSE’s 10-year average P/E of 16.7 times, we gain some perspective into why they consider its current P/E of 19.5 as an expensive level. At least it isn’t 24, a level last reached in 2016, but much like the R30 bottle of Coke, it definitely still isn’t cheap.  

Investors chasing after higher dividend rates, on the other hand, will tell you that they don’t find the proverbial Coke to be expensive at all. At a current historical dividend yield of more than 3% (before dividend withholding tax), you now earn more dividends compared to the 10-year historical average of 2.9%. In other words, shares are priced more reasonably according to their valuation method. 

Then there are analysts who believe that the price-to-book ratio (P/B) is an even better tool to determine the value of a share. This method compares the market value of a particular share to its book value. The lower the P/B, the more undervalued the share.

Although it may be easy to Google the price of a two-litre Coke in Europe, it’s not quite as easy to interpret the abovementioned data collectively, so we decided to build a model that combines the P/E, inverse dividend yield and P/B, and then normalises the data. We were amazed by the results. 

When we combine these valuation methods, we can clearly see that one of the best times to buy was between the second half of 2011 and the first half of 2012. It also shows us that the JSE was truly expensive around mid-2016, which could definitely be considered as one of the reasons why we have experienced very limited market growth over the past two years. But, most importantly, what this graph shows us is that the JSE (based on historical prices) at current levels definitely isn’t expensive.   

I’m well aware of the fact that historical data bears no guarantees for future performance, but if you are considering selling your local shares, make sure you do it for the right reasons. Don’t base your decision on the findings of only one indicator that may have shown you that your shares are expensive.

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 7 June edition of finweek. Buy and download the magazine here, or sign up for our weekly newsletter here.

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investment  |  valuations  |  stock exchanges
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