European equities are considered to be cheap relative to US equities, after the latter went through a year of strong multiple growth, but this is only true if earnings begin to recover on time so that normalized earnings give an accurate picture of euro area stocks’ value.

“European equities look expensive when valued using current earnings, but cheap if we assume normalized Earnings,” writes Morgan Stanley analyst Matthew Garman. “The investment case for owning European stocks is heavily dependent on the extent of ROE recovery.”

eu valuation current earnings Eurozone

eu valuation normal earnings Eurozone

Normalized PE can obscure permanent drops in value

Normalized earnings are often used for valuations to average out fluctuations that could give investors the wrong impression of a company if there happens to be a temporary bump or dip when earnings are checked. The problem is that if the dip isn’t temporary, normalized earnings can obscure the loss of value. Eurozone return on equity (ROE) needs to recover significantly this year for prices based on normalized earnings to be justified.

Garman argues that the reason Europe’s ROE is weak isn’t because economic performance is lagging, but because Europe is more exposed to energy, materials, and financials than other economies, so there is a greater structural drag on ROE.

“While European ROE is 3.9% lower than in the US, a third of this gap can be entirely explained by differences in sector weights,” he writes.

Eurozone equities trading at a relative premium

“Although our economists expect lacklustre growth in the Euro Area, their forecasts could still be consistent with an ROE of 13% by the end of 2015 versus 11% today,” writes Garman, but even then the Eurozone would be expensive compared to its own long-run average (a 22% premium) and at less of a discount compared to MSCI World than you would normally expect.

ROE analysis implies that Europe’s relative trailing PE discount to MSCI World improves from 3% to 12%. However, valuations would still remain above their long-run average discount of 16%,” Garman writes.

EU ROE recovery 0114 Eurozone

So even in the case where Europe’s economic recovery continues without incident and ROE largely recovers, it may not be enough to pull the region’s PE back down to the historic average relative to world markets.