Last week, we compared stock valuations in Australia to the rest of the world. The upshot? The local market is one of the most richly priced across Morningstar’s global coverage list, even eclipsing the overvalued US equity market. This is not a call to sell all Aussie stocks. The ‘culprits’ skewing valuations are a handful of big, expensive companies. Think the major banks (excluding ANZ) and market darlings like Wesfarmers (ASX:WES) and Goodman Group (ASX:GMG) . We still see many opportunities across our Australian coverage, some of which we will explore below. Nonetheless, when the market departs meaningfully from our estimate of fair value, it’s worth asking questions. This week, I’ll tackle two. First, how does today’s premium compare to valuations in the past? And second, what might it tell us about future returns?

Today’s market in context

Our equity research database holds roughly fifteen years of ratings for ASX-listed stocks. During this time, we’ve seen all sorts of markets: a mining boom and bust, the rise of Trump, the US-China trade war, a war in Europe, a pandemic, an inflation surge, and so on. In short, we’ve got a reasonable sample against which to benchmark today’s market. But first, how can we value the Australian stock market? There are many approaches an investor can take. For us, it starts with our individual stock ratings. Take Commonwealth Bank (ASX:CBA), for example. On Jan. 22, 2025, CBA closed at $158. Our fair value estimate for CBA, derived from our discounted cash flow model, is $95. Dividing the market price by the fair value gives us a price/fair value ratio of 1.66. Expressed another way, CBA trades at a 66% premium to fair value. By market capitalisation, CBA is the largest company on the ASX, accounting for roughly 10% of the ASX 200 index. By multiplying CBA’s price/fair value with its index weighting, we can calculate CBA’s contribution to the total market valuation. If we repeat this for all the Australian stocks we cover (nearly 200) and sum these together, we get an aggregate price/fair value ratio for the Australian market. I’ve plotted the aggregate price/fair value ratio for the ASX 200 index over the last ten years [Exhibit 1]. This is only a subsample of our total Australian equity coverage (we also cover stocks outside the ASX 200), but it should be fairly representative. As suspected, the chart suggests we are in unusual territory for Australian equities. Though today’s market isn’t completely unprecedented—we saw similar valuation during the frothy post-pandemic period.

Exhibit 1: Unusual territory for Australian equities

Market Cap Weighted Price/Fair Value, ASX 200 Index

Note: If a stock is not covered by a Morningstar analyst, the Morningstar Quantitative Equity Research Rating is used. Source: Morningstar.

What do valuations suggest about future returns?

Howard Marks, co-founder of Oaktree Capital Management, recently published a fantastic memo. Marks is famous for, amongst other things, warning of bubble-like behaviour during the dot-com boom—right before it dramatically burst in the early 2000s. I won’t rehash the article here but highly encourage subscribers to take a look. It’s accessible on Oaktree’s website. There are many gold nuggets in Marks’ note. But let’s home in on a particular chart from J.P. Morgan Asset Management [Exhibit 2]. On the vertical axis, we have the price/earnings ratio of the S&P 500 each month from 1988 to 2014. And on the horizontal axis, the annualised return of the S&P 500 in the ten years that followed. The relationship is remarkably consistent: the higher the price/earnings ratio, the lower the future returns. And, as the chart shows, US equities currently trade at an abnormally high multiple.

Exhibit 2: S&P 500 forward P/E ratios and subsequent 10-year returns

Source: JP Morgan Asset Management, as cited by Oaktree Capital Management. Let’s run a similar experiment on the Australian market. But instead of price/earnings, we’ll use Morningstar’s proprietary price/fair value ratios. Because we have a shorter history of Morningstar ratings, I’ll plot valuations against three-year forward returns, rather than ten. [Exhibit 3]

Exhibit 3: ASX 200 price/fair value ratio and 3-year forward returns

Source: Morningstar What does the chart show? First, like the J.P. Morgan chart, it indicates a negative relationship between valuations and forward returns, at least during the last decade. To make it easier to see, I’ve drawn a line of best fit. Using this, we find today’s price/fair value ratio has historically been associated with returns of around 4% per year. But this should not be interpreted as a forecast. For starters, the range of historical outcomes is vast. If we take the handful of examples when the market has traded at a similar level to today, we’ve seen annual returns above 5% and as low as 1%. Making any sort of forecast with such volatile data would be fraught. We also had a pandemic in the middle which created a big distortion. But the chart suggests our ratings have historically provided a useful signal for stock returns. And if the next three years perfectly replicated the average outcome over the last decade (a heroic assumption), we could be in for returns of 4% per year. That’s below the historical average for the ASX, but whether it’s a fair return for taking on equity risk is up to the investor.

Where we see value amongst the large caps

While expensive large caps are the biggest contributor to our market’s overvaluation, this doesn’t mean we don’t see opportunities. In fact, five of the largest 20 stocks on the ASX trade below fair value: ANZ (ASX:ANZ), CSL Ltd (ASX:CSL), Santos (ASX:STO), Telstra (ASX:TLS), and Woodside (ASX:WDS). We’ll briefly touch on the last three. Subscribers can find further information on these stocks on morningstar.com.au.

Telstra

• Price/Fair Value: 0.88
• Star Rating: ★★★★
• Moat Rating: Narrow
• Uncertainty Rating: Medium
• Capital Allocation: Standard

Telstra is the leading telecommunications services provider in Australia. It has dominant market share in each service category and customer segment, and enjoys cost advantages which underpin its narrow moat rating. While competition is robust, Telstra’s mobile market share is likely to prove resilient. Telstra’s infrastructure provides the most comprehensive coverage for fixed-line, mobile, and broadband in Australia which drives reliable cash flow. While it is not the cheapest provider of telecommunications services, it is the lowest-cost provider, resulting in EBITDA margins of over 30%. Shares trade some 12% below our fair value estimate. In our view, a new strategy to improve ROIC, not just by cost-cutting but by adequate pricing and monetisation of the immense capital deployed, would help close the stock price discount.

Woodside

• Price/Fair Value: 0.61
• Star Rating: ★★★★★
• Moat Rating: None
• Uncertainty Rating: Medium
• Capital Allocation: Standard

Santos

• Price/Fair Value: 0.71
• Star Rating: ★★★★
• Moat Rating: None
• Uncertainty Rating: High
• Capital Allocation: Standard

Santos shares have fallen roughly 5% since mid-2023, while Woodside is down some 30%. Both have greatly underperformed the broader market. But the outlook for cash flows remains robust. Even though some think the end of hydrocarbons is nigh, oil and gas demand is growing. Investors should be wary of calls for near-term peaks in oil demand. Historically, similar calls were based on improbable assumptions and proved wrong. And naturally declining supply means significant hydrocarbon investment is required in most demand scenarios. Both companies trade on a materially lower multiple than global peers. Within a decade, we see Woodside shares heading toward $50, and Santos toward $15, under conservative assumptions.