European equities are significantly below the longer-term average and offer potential to double in five years, according to a recent research report from Barclays PLC (NYSE:BCS) (LON:BARC) analysts Ian Scott, Dennis Jose, CFA, and Joao Toniato, Ph.D.

Ian Scott and team at Barclays PLC (NYSE:BCS) (LON:BARC) feel the European stock market appears cheaper than the trailing PE currently indicates.

European equities look cheap

After performing various tests across the broad range of valuation metrics, Barclays’ analysts observed that other than the trailing PE multiple, European equities are still at a significant discount to the longer-term average. The analysts found that due to the current level of EPS remaining quite depressed, European equities may be looking artificially more expensive than they should.

However, considering the analysts’ view on earnings picking up in the coming years, they feel European equity markets appear cheaper than the trailing PE currently indicates.

The following graph highlights European stock markets look cheap, on all parameters except the trailing PE:

European Equities

European stocks could double in five years

Barclays’ analysts note on the cyclically adjusted PE (CAPE) basis, pan-European stocks are still 26% below the long-term average. This is evidenced from the following graph:

European stocks below long term average

The analysts point out that despite their strong performance year-to-date, European stocks are still cheap on this metric. The analysts also note that CAPE tends to be a strong predictor of future market returns with R-squared of 56%. Particularly, the analysts believe the current CAPE of 13.9x has been typically followed by the market more than doubling on a total return basis over the following five years.

By taking a deep dive, and by looking at time horizon from 1 to 5 years, the analysts observed that on average, current levels of valuation point to total returns one year ahead of about 10%, while longer-term, on a 3-year time frame, prospective returns could range from 40 to 60%. However, when viewed from a 5-year timeline, the Barclays analysts believe the stock market could easily double in total return terms. The following graph strengthens the analysts’ views:

Projected Valuations across timelines

Europe looks cheaper relative to global markets

By taking a global view, the Barclays analysts point out that relative to global equity indices, European equities appear to be offering value. As can be seen from the following graph, by plotting the cyclically adjusted PEs for the major global equity indices, the analysts observe that the majority of the indices that feature on the cheaper side are from the euro area including Greece, Italy, Spain and Ireland:

Relative global valuation

Ian Scott and team at Barclays PLC (NYSE:BCS) (LON:BARC) feel European stock markets are ripe for re-rating as they feel the shift to European equities has only just started, with recovery in European economy aiding such re-rating.

By taking a sectoral view, Barclays’ analysts believe that, given the inflection in EPS momentum, they prefer cyclical as compared to defensives.

Apart from preferring value to growth, the analysts are overweight on various sectors such as financials, chemicals, mining, industrials and energy. However they suggest underweighting on consumer staples and healthcare.

The following table highlights the analysts’ forecasts and targets:

Barclays' forecasts and targets