By Hawksworth, John
European Business Forum , No. 7
European equity markets have grown significantly relative to the size of their respective national economies since the mid-1990s (see Figure 1) but, as in the US, share prices were pushed to unsustainable levels in early 2000 only to fall back since then. It remains uncertain, however, whether this adjustment has returned markets to fair values, or whether there might be further downward corrections.
In this article, we use a variety of historical benchmarks and models to address this question, using data since the early 1970s on the US, the UK and the five largest Euroland markets (Germany, France, Italy, the Netherlands and Spain). It should be noted that, for the purposes of this analysis, we have adopted a valuation date of the end of June 2001. Since then equity markets have declined significantly, both before and after the tragic events of 11 September when terrorists attacked the US. Our estimates of fair market values therefore apply only to the end of June and need updating for subsequent events, as discussed later in this article.
Backward-looking valuation ratios
Any such assessment of 'fair values' for equity markets is inevitably subject to significant uncertainties given the need to make assumptions on two variables, the required return on equities and the future growth of dividends (or corporate earnings), that are not directly observable. Certainly it is not possible to use this kind of analysis to predict short-term movements in share prices or as a guide to short-term investment strategy. On the basis of the historical evidence reviewed in this and other studies, however, we find that for all of the countries considered except Italy (where past figures are affected by what appears looking forward to be an unsustainably high real dividend growth rate), dividend yields at the end of June 2001 were well below historic averages and price-earnings ratios were well above average at that date.
[FIGURE 1 OMITTED]
Since dividend payout ratios have recently fallen below historic average levels (except, yet again, in Italy), we consider that price-earnings (P/E) ratios are the more reliable of these two simple valuation ratios. On their own, these P/E ratios imply that equity markets were around 25-65 per cent overvalued at the end of June 2001, with the exception of Italy (where the estimated 5 per cent overvaluation is too small to be of any significance). This might imply future declines in these equity markets of around 20-40 per cent from end-June 2001 levels to bring them back to fair value, although it says nothing about the timing of any such correction.
Forward-looking valuation model
Rather than relying only on historic P/E ratios, however, we have also made use of the forward-looking dividend growth model, which allows estimates of the 'equilibrium' dividend yield to be derived given assumptions on real government bond yields, real dividend growth and the required equity risk premium. We apply this model based on the assumptions that: future dividend growth is in line with consensus forecasts of real GDP growth and inflation; there is an equity risk premium of around 4-4.5 per cent, broadly in line with historic averages; and actual dividend yields are adjusted to bring them into line with historic average dividend payout ratios. Using this approach, all seven of the equity markets considered (this time including Italy) appeared to be significantly overvalued at the end of June 2001.
More precisely, we find that actual market values at the end of June 2001 were above estimated fair values by amounts ranging (as a percentage of estimated fair values) from around 45-55 per cent in the UK, the Netherlands and Spain, to around 100-110 per cent in Germany and Italy. The US and France showed intermediate levels of overvaluation in the 75-85 per cent range. If correct, these estimates would imply that declines in the share price from end-June 2001 values of the order of 30-50 per cent would be needed to bring these markets broadly back into line with estimated fair values. …