Australia’s ASX at a key point as valuation looks stretched

Australia’s ASX 200 index is at a key point in terms of price-to-earnings valuation. History suggests that either earnings estimates need to rise or share prices fall. The key decider will be commodity prices.  

Australian Stock Exchange
Source: Bloomberg

The ASX 200 is at an increasingly precarious point in valuation terms. Its forward price-to-earnings ratio is at a level that has often in the past resulted in sharp corrections. Earnings per share (EPS) estimates are incredibly negative, possibly overly so. This means that either earnings estimates begin to improve or prices collapse.

This contradiction largely boils down to commodity price forecasts and their weight in longer-term stock valuations for this commodities-heavy index. The most 'stretched' valuations are in commodity-related sectors, but there is a perfectly valid case to argue that commodity prices will be higher in 12 months or more.

The future price-to-earnings (P/E) ratio can tell traders if the valuation of the ASX 200 is 'expensive' or 'cheap' relative to its long-run average. The current valuation levels in the ASX are at historical warning levels, and historical precedent tells us that these levels are often subject to a reversal. 

The forward earnings estimate reflects the market consensus for future earnings growth. On the positive side, forward EPS estimates have rarely dropped below 1 standard deviation, and, should we avoid a recession, EPS forecasts look set to improve throughout the year.

Which sectors are looking strong?

Looking at sector performance, the drop in the Australian dollar has clearly helped Consumer Discretionary and Healthcare’s solid one-month returns.

In forward P/E terms, Financials look the least over-valued according to their historical averages.

But in enterprise value-to-earnings before interest tax, depreciation and amortisation (EV/EBITDA) terms, Consumer Discretionary and Industrials have a noticeably lower valuation premium.

Top ASX value stock picks:

Monadelphous has had a tough time of late. Its a mining services engineering stock and mining capex has dived. But, the worst of the commodities sell-off looks to be over. Forward earnings estimates for the stock are still pretty dismal going out a number of years, but much of this has been factored into the price.

The stock is still offering an over 8% dividend yield on 2016 estimates, and should the dismal capex forecasts out to 2018 show even the slightest improvement, the stock is primed to be a key beneficiary. Currently seven analysts have the stock at 'hold', seven at 'sell', and none at 'buy'.

Western Areas Ltd, the embattled nickel miner, is struggling with spot nickel prices below breakeven price and a poor near-term outlook for its key product. However, the company looks to have enough cash to survive the downturn and should continue as a going concern.

At A$2.00, its valuation is so cheap it is almost a binary bet on whether the stock goes bankrupt or not. If not, the February bottom of A$1.84 looks like the worst of the sell-off and a steady improvement in the nickel price and a lower Aussie dollar are both likely to help the stock edge higher in the future. Currently, five analysts have the stock at 'buy', eight at 'hold' and six at 'sell'.

Downer EDI Ltd, another engineering and construction stock, already seems to be outperforming Monadelphous. The company has a robust balance sheet with low gearing and is increasingly trying to position itself into the oil and gas space now that its LNG-related work is winding down.

The stock also offers a steady 5-6% projected dividend yield based on current earnings forecasts. If sentiment continues to pick up with regards to the E&C space, price growth and dividend payments are likely to lift the stock to healthy double-digit total returns. Currently two analysts have the stock at 'buy', seven at 'hold' and two at 'sell'.

OZ Minerals Ltd has one of the best looking earnings yield (EPS/price) on the index, and against comparable global copper producers it is one of the cheapest looking stocks. It has a much cheaper valuation than local competitor Syrah Resources Ltd. After a massive sell-off in the copper price, the prospects for the metal is improving as demand for electric vehicles is set to steadily pick up.

OZ Minerals is still pretty unloved, but its valuation is very compelling and copper price forecasts are steadily being re-rated, which would explain why its competitors are seeing such an uplift as well. Currently, five analysts have the stock at 'buy', 11 at 'hold' and five at 'sell'.

Qantas Airways Ltd’s stock has suffered a massive correction from a lofty A$4.00, as the oil price has rallied to seven-month highs and the company lowered ambitious revenue forecasts. But now it is beginning to show up on a range of valuation metrics. Its revenue from domestic travel is set to steadily grow as it continues to outmuscle Virgin in their duopoly.

The current price is arguably pricing too much negativity around its international routes and high oil prices. It is trading at a significant discount to global competitors and current earnings are likely to see it provide a 7% or greater dividend yield over the next two years. Currently, seven analysts have the stock at 'buy', two at 'hold', and two at 'sell'.

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