Investor discussions on whether the Canadian equity market is cheap or expensive almost inevitably revolve around the index's trailing price-to-earnings ratio of 20.5 times. But market history shows that the aggregate price-to-book value of 2.05 is a far more helpful barometer.
A study of all price-to-earnings and price-to-book ratios for the S&P/TSX composite since 1994, compared with the future performance of the index, uncovers vital information for investors wondering whether the Canadian equity market is currently expensive or attractive.
My analysis leads to two conclusions. One, that aggregate price-to-book values have been far better than price-to-earnings ratios as a predictor of future domestic equity market performance.
Two, both price-to-book and price-to-earnings are more useful as indicators for three-year benchmark returns than 12-month returns.
Using correlation analysis (basically, a mathematical calculation of how closely two series of data move together – identical lines would have a correlation coefficient of 1.0), price-to-book value was twice as effective as P/E at predicting forward 12-month TSX performance and 70 per cent more effective predicting three-year performance.
Similarly, the relationship between P/E ratio and three-year S&P/TSX composite returns was twice as strong as P/E ratios and 12-month returns. Price-to-book value was 35 per cent better at predicting three-year returns than one-year returns for the benchmark.
The strongest statistical relationship in the study – the most effective market indicator over the past 20 years – was between price-to-book value and three-year average annual returns for the S&P/TSX composite. As price-to-book values rise, forward three-year returns from the Canadian equity benchmark are more likely to decline, which is what one would expect – potential returns fall as stocks get more expensive.
SOURCE: Scott Barlow/Bloomberg
The reason for price-to-book value's forecasting acumen comes down to bank stocks. Domestic banks form 20 per cent of the S&P/TSX composite and drive index returns to a significant extent.
Based on the 11-year market history (maximum available for the subindex) for bank stocks, P/E ratios in the sector have been entirely useless at predicting future stock performance – the correlation is low, almost zero. The price-to-book value for bank stocks, however, has a very high correlation with market performance at -0.74 (remember that 1.0 is the maximum). So, P/Es' lack of forecasting power in this large market segment leads to price-to-book value as the best indicator for investors to watch for the equity market as a whole.
The current price-to-book-value of the S&P/TSX composite is 2.05 times, which is only a smidgen above the 20-year average of 2. This levels suggest moderate returns in the next three years of between 5 and 10 per cent annually.
The caveat, as always, is that past returns and market patterns may not be indicative of the future. It's also true that price-to-book-value works better in some sectors than others. In energy sectors, for example, price-to-cash-flow multiples generate a better market signal.
But at the same time, consistent 20-year market trends should not be dismissed easily. In this case, it suggests that investors looking to guess at broad Canadian equity market conditions should pay much closer attention to price-to-book ratios than price-earnings ratios.
Follow Scott Barlow on Twitter at @SBarlow_ROB.