A fresh look at share valuation techniques
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
Dividend yield
As you know, dividend yield is calculated by dividing the annual dividend of a company by the price of its stock. The successful investor comprehends that when the dividend yield of a stock is at historically high levels, high returns are almost certain to follow. He also knows that the stock is a good investment if the dividend yield is greater than the bond yield. However, when the dividend yield is at a historical high, many investors take fright because of the perception that the business in question may be in trouble.
However, this presents an opportunity for the canny investor who follows a disciplined and systematic pattern of valuation because he will invest in stocks of high quality in these times of fear. This is because he knows that the business is not really deteriorating and is therefore anticipating the upturn in stock prices that must surely follow sooner or later. This is the approach that was successfully followed by the legendary oil tycoon and successful investor John D. Rockefeller who said that the biggest pleasure of investing was to watch his dividends coming in. As a corollary to this valuation principle, low returns follow when dividend yields are at historic lows.
The price-to-earnings ratio [The PE ratio]
Once again, as you know, the PE ratio is calculated by dividing the price of a stock by its earnings per share [EPS]. If the price of a company’s stock is $100 and the EPS is $10 per share, the PE ratio is 10. This means that at the current market price, it will take 10 times the EPS to cover the price of one share. It is a little trickier to determine whether this PE ratio is attractive or not. To do this, the successful investor would examine the historical PE ratios. If the historical PE ratio averaged 18, the stock would appear to be a bargain and is worth serious consideration.
You also have to understand that this kind of situation can occur when
- There is a general panic in the market and investors are not making fresh investments
- Investors believe that the rate of business growth will be lower than they had earlier expected
- Investors believe that the business of the company is actually deteriorating
In other words, if one or more of these conditions are present, the PE ratio will start to decline. However, if your analysis shows that the company is actually in good health despite what investors feel, the relatively low PE ratio presents an excellent buying opportunity.
In general terms, a low PE ratio represents an attractive stock or an attractive market as a whole a high PE ratio signals the opposite. Obviously, paying 10 times earnings is far more attractive than paying 20 times earnings. To pursue this reasoning to its logical end, the successful investor creates a range of PE ratios to gauge the attractiveness of an investment. For instance, he may decide that this range is from 7 to 15. Anything below 7 is suspect unless proved otherwise and anything over 20 is overpriced. Low PE ratios are generally a sign of business deterioration while high PE ratios could be the result of an overheated market.
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