Are FTSE 100 shares still a bargain?

Ben Graham’s The Intelligent Investor was written with individual stocks in mind, but one of its core tenets, that investments can be over-punished for too long, is applicable to whole regions and markets. Arguably, this has been true of the UK ever since the Brexit vote, but after the latest stock market highs, is beaten-up Blighty still a bargain?

World-class companies have always found a home on the London Stock Exchange, but today many operate in unloved sectors of the economy. To an extent, there ought to be a discount for their cyclicality but, on the face of it, the earnings potential of these businesses has been undervalued in recent years, which has an effect on how we view the UK market.

Barclays’ version of the cyclically adjusted price/earnings (CAPE) ratio – which compares price with inflation-adjusted earnings averages over 10 years – has the MSCI UK index looking cheap relative to MSCI’s Japan, US and European aggregate indices. The UK is on a rating of 16, which is below its pre-pandemic level of 18.

Despite the multi-year focus of CAPE, ratings must be judged differently now we’re in a very different interest rate regime, although it is worth noting that today’s UK valuation is also closer to the 2003 and 2009 bear market lows than the highs that preceded those major bear markets. In other words, if you take the view that from here risk will break to the upside, there is something of a margin of safety.

CAPE is a blunt tool, however. Its smoothed perspective of historical earnings doesn’t overcome the shortcoming of being backward looking, so it’s imperative to also use more dynamic valuation methods – ones that consider the relationship between equities, government bond yields and interest rates.

Focusing on large-cap stocks in the FTSE 100 and emphasising the here-and-now, we can be led to conclusions that apparently contradict the notion that UK stocks are cheap. Importantly, this doesn’t invalidate the assertion they are, but model inputs highlight questions to ask when building a case for putting money into individual companies. As ever, the devil is in the detail.

Query assumptions

Right off the bat, we aren’t making a direct comparison with the MSCI UK and we’re only looking at large caps, but given the concentration of the UK market, drilling into the valuations of its biggest members is important.  

For this task, we adapt the methodology used to value the S&P 500 index by Professor Aswath Damodaran of Stern University, New York. This gives some important input choices and settling on appropriate conventions for an index such as the FTSE 100 is likely to require careful observations and subtle tweaks over time.   

Based on the FactSet median earnings growth consensus for the FTSE 100, a UK 10-year government bond yield of 4.3 per cent and a sustainable payout ratio (dividends plus net buybacks as a percentage of earnings) of 36.6 per cent, we estimate the intrinsic value of the FTSE 100 to be 7,972, which is below its lofty height of 8,140 at the time of writing.

Why the disparity? Well, you have to go into the estimate components, but the eagle-eyed will spot that sustainable payout ratio seems low by FTSE 100 standards, where the cash payout has been around 75 per cent in the past 12 months. Other choices are how to estimate a compound annual growth rate (CAGR) for earnings and deciding on conventions for an equity risk premium (ERP) – the required excess return for shares over government bonds.

The gross redemption yield on the 10-year UK government bond (gilt) itself is used as the baseline risk-free rate in our model, so the fact yields have risen on revived inflation expectations directly affects the computation of fair value for shares.

Yet, despite higher bond yields, UK share prices have continued to rise in recent weeks. This makes the picture even more difficult to interpret and adds to the importance of querying assumptions about earnings growth and future cash distributions.

Growth choices

Before diving into the payout calculations, first let’s deconstruct the growth choices we made. Using data from FactSet, we start with the aggregate FTSE 100 earnings for 2023 and use consensus forecasts for 2024 to 2026 to work out year-on-year growth rates. From these and the 10-year government bond yield, which we use as a proxy for long-run growth, we extrapolate a 6.5 per cent predicted CAGR for earnings.

This is realistic but below the 8 per cent for calendar years in the previous decade. One could take that historic rate, which would result in a higher intrinsic value for the index, but if you go back over 25 years, it drops to around 5 per cent, so our forward-looking estimate seems more prudent.

Much depends on the outlook for the biggest companies and sectors of the FTSE 100 – if you believe banks will make more money in a lasting higher rate environment (and maybe regulations could be loosened as governments get desperate to kickstart growth), oil prices won’t face secular decline despite the energy transition, that miners are a durable (if cyclical) investment in global growth and infrastructure needs, and that global demographics favour big pharma, 6.5 per cent may prove too conservative.

Cash flow choices

Next we get to the most difficult and contentious choice – what is a sustainable level for payouts by FTSE 100 companies? Culturally, UK investors are thirstier for income than peers in other regions, and dividends reinvested have a pronounced effect on total returns. Add to this the trend in recent years of companies conducting enormous buybacks and the UK market has a very high payout ratio.

We calculate the recent payout ratio using average net cash yield for the index over the past decade. This figure – average market value of the index over the year divided by the net cash distributions (dividends plus buybacks less equity placings) – averaged 5.3 per cent in the past decade. Applying that to the value of index equity at the start of the most recent quarter, we can expect 77 per cent of the earnings forecast paid out.

This figure is high, even for the UK, so to estimate the cash flows we will discount for our present value calculations, we want to adjust down to a more sustainable payout ratio over time. We do this by dividing the 10-year bond yield by the average return on equity for the index over the decade (but excluding the anathema of the 2020 pandemic year) and subtracting the result from one. This gives a sustainable payout ratio of 36.6 per cent.

Reducing the annual payout ratios incrementally to this level has a big effect on the discount rate we apply in our intrinsic value calculation. It is the prime reason to suggest the FTSE 100 isn’t cheap but seems to underplay the pre-disposition UK-listed companies have to bestow cash windfalls on their shareholders. If we round up slightly, the picture changes somewhat markedly. Raise the sustainable payout ratio to 37.5 per cent and you get a value of 8,152, suggesting the index’s latest charge is perfectly justified.

The table below uses the 37.5 per cent sustainable payout and discounts cash flows per year at 8.1 per cent (a risk-free rate of 4.3 per cent plus a 3.8 per cent equity risk premium). The output suggests the FTSE 100 is now close to fair value, but a fall in interest rates or a rise in earnings growth assumptions would support a higher price for the index.

Choice of equity risk premium

Our final choice is inexorably linked to the idea of investment returns as compensation for opportunity costs and risk. If you’re putting capital to work in a risky venture such as a business, you want the inducement of a higher potential return than you could make risk-free. The slimmer the chances of success the higher the reward must be to tempt investors to look beyond probability of failure.

This dynamic is manifest in the equity risk premium (ERP) – the excess return investors in shares want over the risk-free yield on a quality government bond held to maturity. When working out the intrinsic value of the index, we must select a fair level of ERP. This could be done with an average of past implied ERPs (see below) or what has been observed over the long run.

We’ve taken the UK equity premium calculated for 1900-2023 by Triumph of the Optimists and UBS Global Returns Yearbook authors Elroy Dimson, Paul Marsh and Mike Staunton. This 3.8 per cent annualised premium for shares over bonds is based on nearly a century and a quarter of data, so takes in all sorts of disasters and isn’t overly skewed by the great bond bull market in the 35 years or so before 2021.

Our intrinsic value calculation must imply the discounted expected cash flows will deliver the risk-free rate plus the ERP.

We use the same logic in reverse from the actual price to work out the current implied ERP and this is another way of assessing value.  Priced at 8,140 and factoring in a sustainable payout ratio of 36.6 per cent, the implied ERP is 3.72 per cent – an indicator the index is slightly expensive but not massively overbought. Use a payout ratio of 37.5 per cent and the implied ERP is pretty much bang on the long-run 3.8 per cent observation.

But is that good value for the risk of investing in UK shares? Dividing this premium by the 15.5 per cent 10-year annualised volatility of the FTSE 100 total returns index gives 0.25 as an implied Sharpe ratio. This measure of return relative to risk is favourable to the observed figure of the preceding decade. A premium of 3.2 per cent meant a Sharpe Ratio of 0.2 so any notion the FTSE 100 isn’t cheap on a risk-adjusted basis effectively asserts that between now and 2034 we’ll see more overall volatility than the years that brought us Brexit, Covid and an inflation surge.

That’s a sobering thought if you’re a pessimist, but for those of a positive bent – which describes investors by definition – it’s an opportunity.