Module 3 Evaluating The Market - P/E Ratios

P/E ratio is used extensively as a quick evaluation tool. It can be used to evaluate the market (Index) relative to its history or to other markets. What is a P/E ratio: It is the ratio between a share’s price and profit (earnings). It is calcualated by dividing the price of the share by the latest annual earnings per share of that company. This is called the Price/Earnings ratio or P/E. The P/E of an index is the weighted average of the P/E ratios of all the shares that constitute the Index. It is important to note that P/E is not a percentage, but a ratio. The P/E is the exact inverse of the earnings yield (earnings divided by price) which is a percentage. How does it work: P/E is used more often than earnings yield as an evaluation tool because it moves in the same direction as price. Let me explain. Earnings are normally declared only twice a year by a company. With earnings stable for 6 months, the P/E will go up when the share price goes up and come down when the price comes down. For example: Share A is trading at R10 and the latest annual earnings per share (EPS) is R2. The P/E is therefor 5 (10 / 2), or 5 times. If the price of A increases to R12, the P/E increases to 6 (12 / 2). However, if the earnings increase (after 6 months), the P/E declines. Company A announces a 25% increase in EPS to R2.50. If the share price is still R12, the P/E will fall to 4.8 (12 / 2.5). Using P/E to evaluate markets: Historically: Equity markets or Indices can be evaluated relative to its own historical P/E and other world markets. By looking at historical levels, the index can be rated cheap or expensive. Our All Share Index looks relatively expensive compared to its historical P/E (see graph). The JSE was quite cheap in 2003 when the P/E was close to 8. Since then the market rerated and is now trading on a P/E of 16.

JSE All Share Index P/E Ratio
20

18

16

14

12

10

8 Feb-99

Feb-00

Feb-01

Feb-02

Feb-03

Feb-04

Feb-05

Feb-06

Relative to other World Markets: It is also possible to evaluate an index relative to other world markets. Comparing the JSE with other world markets, all factors pertaining to our market must be taking into account. For instance: economic growth, productivity, inflation, exchange rate, profit potential etc.

World Markets P/E Ratios
Dow Jones S&P 500 JSE Footsie 100 Australia 22 17 16 13

Selecting a share - Fundamental analysis: Dividend Yield Understanding dividend yield as a valuation tool and building a high-yielding portfolio. Dividend yield and the Price/Earnings ratio (P/E ratio) are two of the most important valuation tools available. Dividends are declared by a company out of profits and are payable to shareholders registered in the company’s books at a certain date. Most companies declare an interim as well as a final dividend in every calendar year. The annual dividend is therefore the latest final plus interim dividend available. The dividend yield is simply the annual dividend per share divided by the current share price (div per share/ share price). Therefore, if the share prize goes up and the dividend stays the same (dividends only change twice a year in any case) the dividend yield will decrease. If the dividend increases and the share price stays the same, the dividend yield will increase. Using dividend yield as a valuation tool. High dividend yields: Shares with high dividend yields are generally considered cheap. But do not rush in to buy all shares with high dividend yields. There is usually are very good reason for a share to be rated cheap. You will notice that we refer to shares as cheap by looking at the dividend yield. A share trading at R100 with a dividend yield of 10% is much cheaper than a share trading at R10 with a dividend yield of 5%. The reason is that you get a much higher return on the R100 share. Some of the reasons why a share may be rated cheap are: very low growth in dividends, high volatility in dividends, negative profit outlook, high risk sector, etc. Property loan stock and property unit trust companies have high dividend yields because there is usually no dividend growth. The average dividend yield for the sector is 16%, which is a lot higher than deposit rates. There is obviously more risk involved in investing in a share than depositing money with a bank because there is no guarantee that the dividend will be paid. Therefore the high dividend yield indicate high risk. Commodity stocks are usually very volatile and profits can be high in one year and very low in the following year, resulting in quite high dividend yields.

Low dividend yields: Shares with low dividend yields are considered expensive because of the low return on capital. Again there are good reasons why investors would buy a share with such a low current return. Normally it is because of the company’s excellent profit potential. Information technology shares usually trade at a very low dividend yield because future profits look exciting. If profits increase the dividend yield will also increase based on the cost of purchase. Unfortunately past dividends are no guarantee of future dividends. Historical dividend yields, however, give an investor valuable insight into market perspectives about the share. Market perspectives change constantly as the broader economy, market sentiments and the company’s fortunes change. Using dividend yield to evaluate the market: Dividend yield can also be used to evaluate market perceptions of the market as a whole. That is usually done by comparing the dividend yield of the overall market index with other global markets or with its own history. Gerhard Lampen. Head - Sanlam iTrade.

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