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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







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 22
S&P 500 17
JSE 16
Footsie 100 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.