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This Global Paper was prepared by Peter Oppenheimer, Jessica Binder and Anders Nielsen
Jim ONeill, Peter Oppenheimer, Kathy Matsui, Tim Moe, David Kostin and Dominic Wilson February 6, 2009
Summary
We introduce a 4-stage dividend discount model that is estimated in the same way in each major region. This is used as a valuation anchor for international comparison. In generating results from GS DDM, we have taken three approaches. 1) Fair value today using our central scenario (how should we think of equities relative to current bond yields?). 2) Fair value today using fair value bond yields, based on our Sudoku model (how should we think of equities assuming bonds were fairly valued in the current environment?). 3) Equilibrium value using long run average real bond yields and ERP (how much of the current valuation gap is due to the fact that the discount rate is higher/lower than normal?). We estimate that the upside to fair value given the current economic environment and bond yields is, 15% in Europe, 11% in the US, 4% in Asia ex Japan and 3% in Japan. Adjusting the fair value for current fair value bond yields increases the undervaluation in all equity markets. On a long run Equilibrium Value basis we find an upside to fair value of 71% in Europe, 36% in the US, 31% in Asia ex Japan and 13% in Japan. We estimate the upside to long run equilibrium fair value by using a real interest rate of 2% and an equity risk premium of 3% (except in Asia ex Japan where we use 4%) in our dividend discount model. Chart 1 shows that the deviation of market values from long run equilibrium levels tend to close over time. One percentage point of additional upside to fair value at the beginning of the year on average increases the total return during the year by 0.3 percentage points (Chart 2). Chart 2 also shows that the upside to fair value explains 15% of the variation in yearly returns.
Table 1: GS DDM Fair-value and equilibrium levels
Central Scenario Current Level 846 195 786 266 Fair Value Level 941 224 809 277 Fair Value Upside / (Downside) 11% 15% 3% 4% Using Sudoku Fair Value Bond model Fair Value Level 943 274 916 NA Fair Value Upside / (Downside) 12% 41% 16% NA Using equilibrium ERP* and 2% real interest rate Fair Value Level 1152 333 886 349 Fair Value Upside / (Downside) 36% 71% 13% 31%
US (S&P 500) Europe (Stoxx 600) Japan (TOPIX) Asia (MSCI APxJ)
Overvalued
y = 0 .3 19 7 x + 9 .2 16 2 R 2 = 0 .14 5 7
Undervalued
-60% Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07
20
40
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We introduce a common basis for the global valuation of equities with GS DDM
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Valuation as a fair value guide Our intention in this paper, Part I of a two part series, is the following. To have a model that is estimated in the same way in each major region so that a consistent benchmark for fair value can be established. In this way we can compare valuations across regions and also relative to history. Develop an approach that lends itself to reverse engineering assessing what assumptions the market is implying. This can be particularly useful at turning points or periods when the market appears to have deviated materially from fair value. If a market appears expensive, then what kinds of assumptions would be required in order to justify such valuations? To generate an assessment of Fair Value for the market by applying assumptions about it (bond yields, ERP, earnings etc). To establish an Equilibrium Level level for the markets by assessing the fair value assuming that the ERP converges to a long run average level and real bond yields are at their long term trend. Valuation as a forecast tool The forecast returns approach attempts to assess how quickly the convergence of prices to fair value is likely to happen. In a separate report, Part II of our Valuation series, we intend to invert the fair value model presented in this paper to back out the ERP required to equate market levels to the theoretical fair value. By doing this at different points in time we generate a time series of the implied equity risk premium. We then analyze the relationship of the premium with macroeconomic variables, allowing us to forecast the ERP and, therefore, market levels.
1&2 5%
3&4 5%
5 to 20 23%
Beyond 20 67%
Time
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Phase I: Forecast growth years 1 and 2 We use our top-down estimates for operating earnings growth for year 1 and year 2. For each year, we adjust the previous years payout ratio by a factor that relates to the forecast growth rate (for example if earnings are expected to rise rapidly, we assume that last years payout ratio falls moderately as dividends are more stable than earnings). Phase II: Fade to trend ROE years 3 and 4 We assume that the market gets back to trend ROE by the end of year 4 and that the earnings change to achieve this occurs equally over the two years. In a normal part of the cycle this may not result in very different growth in earnings from an average year but at major turning points it could result in quite a large jump in growth in either direction. Having an assumption that gets back to a long-term trend is important. Without it, for example, a model could imply ongoing growth from an unsustainably high (or low) level following a boom (or collapse) in profits. Growing from an unsustainable high or low level of profits would alter the implied fair value materially. Phase III: Long-term growth rate years 5-20 We assume that profits grow at their trend rate of growth (equal to the longterm real economic growth rate plus inflation) but assume that the proportion paid out by companies over this period equals the average of the past 5 years. Phase IV: The terminal value We assume that any profits growth in perpetuity is offset by a commensurate change in the payout ratio; this way we ensure that the return on equity is equal to the cost of equity and profits grow in line with trend real GDP. Other key assumptions for current fair value In order to calculate a fair value, we also need estimates for the following. Risk-free rate: We use the current 10-year bond yield for each of the regions (for Asia we use a cap-weighted average). Inflation: We have settled on a 5-year moving average of core inflation as the most stable and consistent measure of expected future inflation that is easily measurable in each region. ERP: While we intend to model the ERP separately in our valuation forecast paper, we cannot use the results of that model as an input into the DDM because it becomes circular (the DDM fair values are used to extract the historical series of ERP). Consequently, we are constrained to making an assumption for the ERP in this model. This is an important limitation since we cannot observe the required ERP directly at any time. For the purposes of our central assumptions used in our assessment of current fair value, we make an assessment about the current appetite for risk, and chose an ERP by reference to the long run ERP series from our ERP model (to be discussed in detail in a follow up report). Currently, for example, we use an ERP of 5% for the developed markets and 6% for Asia, which is in the top quartile of the historical distribution. While changing the assumption for the ERP can make big differences to the output of the model, we examine the sensitivities to these assumptions later in this report. While we do make an assumption about the ERP for our central case assessment of fair value, we also assess the equilibrium level of the market by assuming the ERP and real bond yields are at their long run average.
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Where
TV = =
And
Et is earnings in period t. For period 1-4, these are Goldman Sachs Strategists forecasts. For t>4,
Et = E4 * (1 + RGDP + INFL ) t 4
PO1 , PO2 , PO3 and PO4 are payout ratio forecasts, based upon the trailing payout ratio adjusted for expected
future earnings growth. ERP is the Equity Risk Premium.
POIM is the intermediate term payout ratio. We use the trailing 5 year average payout ratio.
POS = 1
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RGDP ERP + r10 INFL is the sustainable payout ratio in real terms.
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1) Fair value today; our central scenariousing current bond yields and estimated current ERP
US (S&P 500) Europe (Stoxx 600) Japan (TOPIX) Asia (MSCI APxJ)
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We also expect to see evidence of the market absorbing disappointing data, both macro economic and company specific, without a negative price reaction. We have argued that an improvement in the credit markets is also required as a prerequisite for a sustained recovery in equities since, on a risk adjusted basis, parts of the credit market have overshot fair value even more than equities (see for example our report of November 14, 2008, Strategy Matters: Credit versus equity: Credit offers better value). Again, in this regard, recent improvements in our Financial Distress Index are also encouraging.
2) Fair value today using fair value bond yields from our Sudoku model and current estimated ERP
10 9 8 7 6 5 4 3 2 90 92 94 96 98 00 02 04 06 08
Source: Goldman Sachs Global ECS Research
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3) Equilibrium value, assuming a long run normalised level of real bond yields and ERP
Comparison of approaches
The three approaches are compared in Table 5. On current assumptions, all markets are undervalued, with the Europe being the most attractive and Japan and Asia the closest to fair value. By applying an assessment of current fair value bond yields as defined by our Sudoku model, the broad conclusions remain the same though the undervaluation of European equities becomes significantly larger.
Chart 4: GS DDM, US equilibrium value % deviation form fair value assuming fixed ERP at 3% and real bond yield of 2%
60%
Chart 5: Returns are higher when the upside to fair value is large at the start of the year
50
40% 20% 0% -20% -40%
Overvalued
y = 0 .3 19 7 x + 9 .2 16 2 R 2 = 0 .14 5 7
Undervalued
-60% Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07
20
40
Source: Datastream, Haver analytics, Goldman Sachs Global ECS Research. Issue No: 179
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US (S&P 500) Europe (Stoxx 600) Japan (TOPIX) Asia (MSCI APxJ)
Assuming the ERP (which we believe is currently unusually high) reverts to a long run average of 3% in the developed markets and 4% in Asia and using a trend average real bond yield, all markets are substantially undervalued. The range of undervaluation is from 13% in Japan to 71% in Europe.
Sensitivities to assumptions
While the model helps to identify the potential upside or downside to fair value, it is very sensitive to changes in inputs and structure. But how much do changing assumptions matter and which variables are the most sensitive? In the section we examine these assumptions and sensitivities in more detail.
Earnings growth assumptions FY3 and FY4 Trend FY1 FY2 CAGR ROE -5% 31% 3% 14% -16% 8% 3% 13% -37% -3% 8% 6% -15% 17% 5% 15%
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Table 7: Sensitivity of fair value for European market to short-term earnings forecasts
shading represents current estimates
Upside / (Downside) to Fair Value varying Return on Equity (trend) ROE US Europe Japan -33% -27% -12% 5.0% -28% -22% 6.0% -1% -23% -16% 7.0% 10% -17% -11% 21% 8.0% -12% -6% 32% 9.0% -7% -1% 44% 10.0% -2% 5% 55% 11.0% 3% 10% 67% 12.0% 79% 13.0% 9% 15% 20% 91% 14.0% 14% 19% 26% 103% 15.0% 24% 31% 115% 16.0% 29% 36% 127% 17.0% Assumption 13.5% 13.0% 6.4%
Asia -39% -35% -31% -26% -22% -17% -13% -9% -4% 0% 5% 9% 13% 14.9%
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substitution and increased leverage, particularly in the financial sector. The current trend ROE assumptions that we have used in each region appear at the bottom of the table on Table 8. Obviously changing this assumption makes a difference to the current fair value. In the case of the US, for example, a return to previous peak ROE (around 17%) would imply about 30% upside to the market. Meanwhile, if we applied a 10% ROE, the market would be overvalued by 7%.
Upside / (Downside) to Fair Value varying Real Long Term Growth LT Growth US Europe Japan -23% -12% -21% 0.0% -19% -7% -16% 0.5% -13% -2% -10% 1.0% -8% 3% -4% 1.5% -2% 9% 2.0% 3% 4% 10% 2.5% 15% 22% 18% 3.0% 11% 19% 29% 26% 3.5% 26% 37% 35% 4.0% 35% 45% 45% 4.5% 44% 53% 56% 5.0% 54% 63% 67% 5.5% 64% 73% 79% 6.0% Assumption 3.0% 2.5% 2.0%
Asia -34% -30% -26% -22% -17% -12% -7% -2% 4% 11% 17% 25% 33% 4.0%
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assumption would raise the fair value upside in mature markets like the US and Europe by 7%-8%.
Table 10: Payout ratios Current, 5, year average and sustainable rate
Payout Ratio 5y sustainable average rate 32.1% 47.4% 40.9% 62.0% 33.8% 62.5% 34.6% 42.0%
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Table 11: Upside/downside in fair value based on various interim payout ratios
Upside / (Downside) to Fair Value varying Interim Payout Ratio Payout Ratio US Europe Japan 5% 1% -5% 25.0% 7% 3% -3% 27.5% 6% 0% 30.0% 10% 8% 32.5% 12% 2% 14% 10% 35.0% 4% 16% 12% 6% 37.5% 18% 8% 40.0% 14% 20% 10% 42.5% 17% 22% 19% 12% 45.0% 24% 21% 14% 47.5% 26% 23% 16% 50.0% 28% 25% 18% 52.5% 30% 28% 21% 55.0% Assumption 32.1% 40.9% 34.0%
Asia -4% -2% 0% 2% 5% 7% 9% 11% 13% 15% 17% 20% 22% 34.6%
does have some impact, as shown in Table 11. For each region the current assumption we use is highlighted at the bottom of the table. Note that Europe has traditionally had a much higher payout ratio than the other markets. In the case of Europe, for example, a fall in the ratio to 35% similar to the other markets would imply the market is currently only 10% undervalued. Put another way, if the other markets were to increase their payout ratio over years 5-20 to similar levels as Europe, it would significantly increase the current degree of undervaluation in other markets. Having different payout ratios over this period from market to market does, however, make sense given the differences in maturity of industries, end demand markets and cyclicatity of the various regions.
Table 12: Upside/downside in fair value based on various risk free rates Upside / (Downside) to Fair Value varying Nominal risk-free rate
Risk-free Rate 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% Assumption
US -23% -19% -13% -8% -2% 4% 11% 19% 26% 35% 44% 54% 64% 2.9%
Europe 233% 172% 128% 94% 67% 46% 29% 15% 3% -7% -15% -22% -29% 3.5%
Japan 57% 33% 13% -2% -14% -24% -32% -39% -45% -50% -54% -58% -61% 1.3%
Asia 539% 377% 272% 199% 146% 106% 75% 51% 31% 15% 2% -9% -19% 4.9%
8 6 4 2 0 Dec-88
Dec-92
Dec-96
Dec-00
Dec-04
Dec-08
Source: Datastream
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Inflation measures 5 year average core inflation Implied by index linked bond market University of Michigan Surveys of Consumers
Source: Goldman Sachs Global ECS Research
Upside / (Downside) to Fair Value varying Equity Risk Premium ERP US Europe Japan 230% 172% 223% 2.0% 162% 128% 151% 2.5% 113% 94% 102% 3.0% 77% 67% 66% 3.5% 50% 46% 39% 4.0% 28% 29% 19% 4.5% 5.0% 11% 15% 3% -3% 3% -10% 5.5% -14% -6% -21% 6.0% -23% -15% -29% 6.5% -31% -22% -36% 7.0% -38% -28% -43% 7.5% -44% -33% -48% 8.0% Assumption 5.0% 5.0% 5.0%
Asia 287% 210% 154% 112% 80% 55% 34% 18% 4% -7% -17% -25% -32% 6.0%
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cannot use the current inputs from this for the purposes of this model as the results would be circular. Instead we take a range of ERP from this model historically and then assume a number relative to the range that we think is appropriate. Clearly this is controversial and is more art than science. But in choosing a number we are guided by the results of our proprietary Risk Aversion Index, among other things. The broad assumption we use currently is that the ERP is towards the higher band of its long run average given heightened uncertainty about the economic cycle, inflation and efficacy of unconventional central bank and government intervention. We currently use the same equity risk premium for all the mature regions of the world at 5% and use 6% for Asia. These levels are significantly higher than long run averages but are justified by the extreme economic conditions. Table 14 shows how even very small changes in the equity risk premium affect the fair value of the different regions, leaving all other assumptions untouched. Wouldnt it be better to fix the ERP over time to get a sense of equilibrium value? This is precisely the assumption that we make in assessing the 'equilibrium' level for the market, using a 3% constant ERP, which is roughly the historical average implied ERP since 1983 for the mature markets. As we have shown, by doing so, the fair value estimates currently would be much higher. Viewed in isolation, a fall back to 3% would justify rises in the equity markets of 100%-150%. There are two problems with this approach. First, there may be good arguments why the ERP could stay higher over the longer term than it has averaged over recent years (related to higher regulation, taxation and so on) and so it is useful to be able to think about market valuation sensitivities to those kinds of shifts as in Table 14. Even in the shorter-term, there are also good reasons why the ERP is justifiably higher in bad economic times than in good ones. This is why we think it is more appropriate to use a higher ERP to assess the current 'fair value' than the 3% average. The linkages between the ERP and the economic backdrop are something that we will explore in more detail in our next paper. Second, in reality, the ERP also tends not to adjust in isolation. Typically it will fall at a time when expectations for a recovery emerge. Under these circumstances, the bond yield may also rise. Table 15 shows what the fair value changes would be under different ERP and bond yield assumptions for Europe currently. A fall in the ERP back to, say 3%, coupled with a rise in the bond yield to, say 4.4%, would imply a 50% upside to the market! The fact that yields and the ERP are not independent is one reason too why in our
Table 15: Sensitivity of fair value for European market to the 10yr bond yield and ERP Shading represents current estimates Equity Risk Premium
2.0% 2.3% 2.6% 2.9% 3.2% 3.5% 3.8% 4.1% 4.4% 4.7% 5.0% 2.5% 318% 263% 219% 183% 153% 128% 106% 88% 72% 59% 47% 3.0% 232% 194% 162% 136% 113% 94% 77% 63% 50% 39% 29% 3.5% 172% 144% 120% 100% 82% 67% 54% 43% 32% 23% 15% 4.0% 128% 107% 88% 72% 58% 46% 36% 26% 18% 10% 3% 4.5% 94% 78% 63% 50% 39% 29% 20% 13% 6% -1% -7% 5.0% 68% 55% 43% 33% 23% 15% 8% 1% -5% -10% -15% 5.5% 47% 36% 27% 18% 10% 3% -3% -8% -13% -18% -22% 6.0% 30% 21% 13% 6% -1% -6% -12% -16% -21% -25% -28% 6.5% 16% 8% 2% -4% -10% -15% -19% -23% -27% -31% -34% 7.0% 4% -2% -8% -13% -18% -22% -26% -29% -33% -36% -38% 7.5% -6% -11% -16% -20% -24% -28% -31% -35% -37% -40% -43%
Current fair values are highly sensitive to the ERP and bond yields
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Table 16: Global stock market recoveries from recession-based bear markets
Returns BEFORE the Trough (%) Returns AFTER the Trough (%) Earnings (%) Length in Total Peak dates Trough dates Months Decline S&P 29-Nov-68 26-May-70 18 -36% 05-Jan-73 03-Oct-74 21 -48% 28-Nov-80 12-Aug-82 20 -27% 16-Jul-90 17-Oct-90 3 -19% 24-Mar-00 09-Oct-02 31 -49% FT All Share 31-Jan-69 27-May-70 16 -37% 01-May-72 13-Dec-74 31 -73% 04-May-79 15-Nov-79 6 -23% 16-Jul-87 24-Sep-90 38 -22% 04-Sep-00 10-Mar-03 30 -49% DAX 17-Nov-69 05-Nov-71 24 -36% 23-Mar-73 06-Nov-74 19 -36% 19-Oct-78 17-Aug-82 46 -22% 30-Mar-90 06-Oct-92 30 -28% 07-Mar-00 12-Mar-03 36 -73% Topix 18-Dec-89 14-Aug-92 32 -61% 26-Jun-96 15-Oct-98 28 -43% 07-Feb-00 11-Mar-03 37 -56% AVERAGE STD DEV 26 11.1 -41% 0.2 12m -34 -43 -23 -12 -27 -23 -56 0 -20 -35 -11 -18 -7 -11 -58 -37 -27 -32 -26 16.0 6m -26 -34 -10 -13 -31 -19 -47 -18 -15 -18 -14 -13 0 -18 -36 -28 -21 -16 -21 10.9 3m -22 -26 -14 -19 -18 -19 -29 -12 -18 -12 -19 -9 -2 -20 -29 -20 -23 -10 -18 7.2 3m 17 10 38 5 19 14 106 21 8 22 20 19 9 8 43 11 8 13 22 23.3 6m 21 33 42 28 13 15 133 15 24 27 30 39 19 17 65 15 36 33 34 27.9 12m 44 38 58 31 34 44 146 39 30 37 28 43 52 40 77 50 54 46 50 26.8 12m after trough -2 -6 -15 -9 32 6 -25 23 -10 19 28 -4 -29 23 -25 -25 10 -1 20.2 P/E DY
at trough at trough 13 7 7 14 30 13 3 7 10 14 11 11 12 9 31 37 31 15 10.2 4.3 5.9 6.7 4.1 2.0 5.3 12.1 6.7 5.8 4.5 5.2 4.4 3.1 3.8 1.1 1.1 1.2 4.5 2.7
'equilbrium value' measures we fix both, using long-run average real interest rates and ERP. This shows how the market would be valued under a 'normal' discount rate and helps to illustrate how much of the market's level can be explained through a discount rate that is different from the 'average'. We think the common practice of using current bond yields but a fixed ERP is a much harder assumption to motivate. While these numbers may look extreme, they are not so unrealistic if we look at what has actually happened in terms of recoveries from major bear markets in the past. Table 16 shows the recovery profile from some of the deepest equity bear markets that were also associated with recessions. Two interesting observations can be made: The pace of recovery over the first 6-12 months from the final low is very high in every case. The lowest return was around 30%. The strength of this recovery is not dependent on the pace of earnings growth that follows the trough. As the third from final column shows, there is a much greater variation in corporate earnings growth following the trough in the market, than there is variation in returns. In effect, this suggests that much of the initial return in the market is driven by a fall in the equity risk premium. These results are, of course, also very close to the equilibrium fair value level that we generate by fixing the ERP at a long run average of 3% and the real bond yield at 2%. Clearly there are many issues with using a DDM approach to estimate fair values; many of the assumptions are debatable and the level of the ERP in particular makes a big difference to the current levels. Nonetheless, our model does suggest there is strong upside to the market, particularly when we apply our own estimates of bond market fair value and assume even modest normalization in the ERP. The ERP is the subject of Part II of this valuation report. Peter Oppenheimer, Jessica Binder and Anders Nielsen
Issue No: 179
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V =
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