The Canadian Equity Market: Is it Cheap?

Adjusting for inflation or inflation expectations plays a critical role in fairly evaluating equity market valuation metrics over time. Canadian inflation history has gone through significant changes since the 70’s going from a period of high and volatile inflation to a period of low and stable price growth.

Price inflation has a direct impact on nominal GDP growth and ultimately growth in revenues. As a result discounting models will provide different results depending on what inputs are being used. In sum, it is sensible to adjust valuation metrics for inflation.


Equity market valuations

The Canadian equity market’s earnings yield is currently at the high end of its 20-year range. However, this chart shows us that the average earnings yield was much higher prior to the 90’s.

However, when adjusted for market interest rates or inflation expectations the earning yield provides investors with a compelling argument suggesting the Canadian equity market is not expensive in both absolute terms and relative to long-term government bonds.

Valuation metric: Earnings yield


Equity market valuations

On a cash earnings basis, yields look much less attractive than they did when looking at the earnings yield. The metric is now approaching levels which have in the past proved to mark an overvalued market.

The cash earnings yield relative to long-term bond yields is close to its average or fair value but when the cash earnings yield is deflated by inflation, equities are in historically overvalued territory.


Equity market valuations

Canadian equities are currently showing the second highest period of dividend yield since 1993, only surpassed by the 2008-09 recession period. However, dividend yields were generally above 3% prior to the 1990 recession.

The real dividend yield is without a doubt historically elevated at just under 1%. In addition, the spread between the dividend yield and long-term bonds has never been this wide, with dividend distribution above that of long bonds, something unseen in the past 45 years.


Equity market valuations

When comparing operating earnings (EBITDA) to enterprise value (EV) we observe that a significant change took place between 1980 and 1995 with the yield falling by over 12 percentage points. However, this ratio is at the top of its 20-year range, a sign that points to an undervalued market.

The EBITDA/EV ratio is also at a relatively high level when compared to the long-term government bond yield, matching the rate seen in the 2008-09 recession. The spread with the inflation proxy points to a similar conclusion since 1990.