19 Jul 2017 Common Trading Misconceptions Exposed
Is a share trading at R100 more expensive than one trading at R10? Is a company trading at R100 a much larger company than one trading at R10? Let’s bust these two misconceptions and explain the correct way to value shares and determine size.
Price ≠ size of the company
We compare Nedbank and Firstrand as an example. Many people think the bank with a share price above R200 (Nedbank) is a larger company than the one with a price of less than R50 (Firsthand). However, Nedbank has only around 50 million shares in issue, while Firsthand has 5.6 billion shares in issue. Multiplying the number of shares with the price gives you the market capitalisation or market value of the share. This is the correct indicator of the size of the company. Firsthand, with a market of R273 million is more than twice the size of Nedbank, with a market cap of R104 billion, despite its share being a quarter of that of Nedbank.
Price ≠ value
A higher share price does not indicate a more valuable or expensive share. For example: Company A has a share price of R10 and company B has a share price of R1. Both companies have the same market capitalisation, R10 billion. Both companies have the same profit, R20 million. Both companies pay dividends, R10 million. It’s just the number of shares issued that differs. Both companies are clearly equally expensive or cheap despite the big difference in share price. How do we determine whether one share is more expensive than the other? Read on.
P/E ratio – an indicator of a share’s value
The price-earning (P/E) ratio is arguably the most used tool to value shares or markets as either cheap or expensive. What is a P/E ratio? It’s the ratio between share’s price and it’s profits (earnings), calculated by dividing the price of the share by the price of the latest annual headline earnings per share of the company in question.
It’s 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 as it moves in the same direction as price. Companies usually declare earnings only twice a year. With earnings stable for six months, the P/E will go up when the share price goes up, and will 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 therefore five times (10/2 = 5). If the price of A increases to R12, the P/E increases to six times (12/2 = 6). However, if the earnings increase (after six months), the P/E declines. If company A announces a 25% increase in earnings per share to R2.50, and the share price is still R12, the P/E will fall to 4.8 (12/2.5 = 4.8). An increase in earnings therefore means that the share will become cheaper with a lower P/E ratio. A decline in earnings will make the share more expensive, and the P/E ratio will increase.
The P/E ratio can be used in two ways to evaluate a share. The share can either be compared to its historic P/E ratio, or different shares can be compared to each other.
Peer group P/E Comparison: This table shows a peer comparison of the major banks. Capitec (CPI) is by far the most expensive with a P/E of 24 and Barclays Africa (BGA) the cheapest at 7.9. There are good reasons for this: Capitec is growing earnings at a much faster rate than the other banks, and Barclays Africa is facing a claim of more than R1 billion. With P/E ratios around 10 and dividend yields of 5% or more, the banks look cheap compared to historical valuations.
Historical P/E Comparison.
P/E ratios can also be used to evaluate markets or indices compared to history and to other markets. The graph shows the JSE historical P/E ratio since 1960. The very expensive 1969 P/E of 26 and subsequent crash can clearly be seen. The very low valuations with P/E ratios below 8 were during the politically turbulent 1980s. More recently, the 2008 crash caused P/E ratios to fall to eight when share prices declined by 45%, but P/E ratios shot up soon after when earnings declined during the recession that followed. The current P/E ratio of 19 means that our market is by no means cheap
Does this mean that you must rush in and buy all the shares with low P/E ratios because they are cheap and avoid all high P/E shares? Definitely not. There are solid reasons why shares or markets are cheap, mainly relating to profit or earnings expectations.