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Time for new way to value equities?

A low interest rate environment requires a new approach to equities valuation, one fund manager says.

Thursday, April 14th 2016, 6:00AM 2 Comments

by Susan Edmunds

New Zealand’s equity market has a price-to-earnings (P/E) ratio of 18.5, compared to a five-year average of 16.2.

But Stuart Williams, head of equities at Nikko Asset Management, said while that seemed expensive, it did not mean the stocks were overvalued.

“Most people who look at equity valuations look at P/E. They look at that and go it looks elevated versus its history, which is true. But history is largely irrelevant when you consider history is full of much much higher interest rates.”

He said when the OCR was 5% or 6%, that was a different investing landscape.

“Equities are elevated but for a good reason, supported by interest rates and in recognition of the quality of a lot of the companies we have in NZ and ticking the box for how good New Zealand is.”

He said investors who had money coming off term deposit had limited options.

“If their money rolls of deposit or if they had some Auckland Airport bonds at 5.5% or 6%, what are they going to do? If they put it in the bank at 2% and pay tax on it it’s not going to pay their Auckland City Council rates.

"People talk about a low inflation environment and that’s correct in an aggregate sense for the Reserve Bank but it’s completely incorrect in terms of what I’d call unavoidable inflation. People feel alright because they can put fuel in their car but in terms of school donations, rates, life insurance, medical insurance, doctors’ visits, none of these things are going down. It forces people into something other than cash.”

He said equities seemed more appealing because people needed income. “This is a good environment for equities.”

While rising interest rates could affect the market he said they were likely to go down rather than up over the coming 18 months.

Tags: equities Nikko AM

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Comments from our readers

On 14 April 2016 at 6:53 am Pragmatic said:
Deja vu: "It's different this time"
On 14 April 2016 at 9:44 am Brent Sheather said:
It’s worth thinking about what Mr Williams is saying here in terms of the discounted cash flow model. The theory says that a share price is simply the discounted net present value of a stock. The very much simplified DCF model is the value of a company’s cash flows in perpetuity discounted at an appropriate discount rate.

Thus what Mr Williams is saying is that the lower the discount rate, which is a function of interest rates, the higher will be the value of the stock. This is quite correct except for the fact that interest rates don’t fall in isolation. As a recent Bank of England report shows the major factor pushing interest rates down globally in the last 30 years has been lower inflation, lower growth and various other factors. So it may not be correct to argue that lower interest rates imply higher price earnings multiples because we are ignoring the top half of the equation ie lower sales growth and thus lower profits and thus lower cash flows. It may be correct but it may not.

Philip Coggan in the Economist magazine frequently argues this point. For example look at Japan in the last 20 years – interest rates have continued to fall but price earnings multiples have fallen with them.

So there is some free CPD but unfortunately it doesn’t involve maximising the value of your business or how to more effectively close a sale.

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