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At this point in our discussion it will be useful for you to understand some important relationships which come up time and again in the analysis of shares.

 

At the beginning of module 4, we explained the difference between “authorized share capital” and “issued share capital". If you are unclear on these concepts, please go back and re-read module 4 before continuing.

 

These relationships which we cover in this module will help you to compare listed shares more easily – both with other listed shares and with the sector indexes. The best way to explain these concepts is with a simple example:

Example 

A company listed on the JSE has been making “widgets” for just over a year and its shares have been trading well on the Alt-X market. The company has 10 million shares in issue, and the price has risen from the 100c par value, at which they listed, to 150c and their first financial statements have just been issued. They have made an after-tax profit of R1,5 million. After a board meeting to review these results the directors decide to pay out a dividend of R500 000 and retain R1 million to help finance future growth.

 

From these facts in the example you can calculate the following relationships:

 

EARNINGS PER SHARE (EPS)

 

In the share market, “earnings” is just another word for profit. So, the Earnings per share (EPS) is calculated by dividing the profit of the company, usually over the most recent year that it has reported on, by the number of shares that it has in issue. In our example,

 

EPS = Earnings (Profit) / Issued shares = R1.5m / 10m = 15c per share

 

The EPS is obviously dependent on the calculation of the company’s profits in the income statement, as well as the number of shares in issue. The number of shares in issue frequently changes as the company uses shares to incentivise its staff, to make acquisitions, or as part of a share buy-back scheme or “scrip dividend”. These ideas will be explained in more detail later, but for now you should understand that the average number of shares in issue during the year is used to calculate the EPS – and this is normally different from the number shares in issue at the beginning of the year or at the end. You will often see a company quoting its “fully diluted” EPS – and by this they mean that they have used the number of shares in issue at the end of the year rather than the average – which is obviously more conservative.

 

When looking at the EPS always make sure that it is for a 12-month year. Sometimes a company will change its financial year-end – usually, after an acquisition, to conform with its new parent company. When this happens, it results in the company having a financial period which is either less than or more than the usual 12 months. You can still calculate the company’s earnings per share by “annualising” the figure.

 

DIVIDEND PER SHARE (DPS)

 

This is calculated exactly the same way as the EPS, except using the dividend. In our example,

 

DPS = Dividend / Issued shares = R500 000 / 10m = 5c per share

 

Dividends per share is also dependent on the number of shares in issue and obviously, also the company’s dividend policy. The board of directors of every listed company, when it has calculated its profit for the year or the six months (the “interim” period), will have to decide on how much of its profit it wants to distribute to shareholders in the form of a dividend. In large, well-established blue-chip shares, there is normally a “dividend policy” such as paying out 30% of the after-tax profit. But some companies pay no dividends because they are investing everything back into the business. Others pay out 100% of the profits – or even more than 100%, if they have surplus cash. Module 11 gives more detail on the subject of dividends.

 

EARNINGS YIELD (EY)

 

The earnings yield is the earnings per share (EPS) expressed as a percentage of the current market price of the share - which in the case of our example is 150c.

 

EY = EPS / Price X 100 = 15c / 150c X 100 = 10%

 

As the share price goes up, the EY will fall and vice versa. It is important to realise that while the EPS of a share changes only twice a year (at the publication of the company’s interim and final results) the share price can change daily. This means that the share price can fall on bad news which came out after the most recent EPS figure and in anticipation of a decline in future profits. This has the effect of making the EY look better – because it is based on an EPS from the most recent financial period – which is at least two months out of date when it is published - and usually more.

 

DIVIDEND YIELD (DY)

 

This is calculated in the same way as the earnings yield except taking the DPS as a percentage of the current market price. Thus, in our example:

 

DY = DPS / Price X 100 = 5c / 150 X 100 = 3.33%

 

The dividend yield is sometimes compared to the interest rate available from a bank on fixed deposit. When interest rates are high they may appear attractive when compared to the DY of listed companies, but you should remember that money held at fixed interest cannot grow – so there is no capital gain. Blue-chip shares on the other hand tend to climb steadily, giving the investor a handsome capital gain in addition to whatever dividends he/she may earn.

 

PRICE:EARNINGS RATIO (PE)

 

The price earnings ratio (also called the “earnings multiple”) is the reciprocal of the earnings yield. In other words, instead of dividing the earnings per share by the price, we divide the share price by the earnings per share.

 

P:E = Price / EPS = 150 / 15 = 10

 

It is interesting to look at the PE for the entire market as an indicator of whether shares are generally overpriced or underpriced. You can see the PE of any share or index by calling it up and then looking at the variable information at the top of the chart:

Shares which trade on a “high multiple” are said to be “highly rated” and vice versa. Thus, a blue-chip share will generally trade on a higher multiple than a speculative share because the flow of its dividends is less volatile and tends to grow steadily.

 

MARKET CAPITALISATION

 

The market capitalisation of a company is the value that the market gives a company at any point in time. It is calculated by multiplying the current share price by the number of shares that the company has in issue. In our example, this would be:

 

Market Cap. = Price X Issued shares = 150c X 10m = R15m

 

Obviously, the market cap. changes every time the share price changes. Most indexes are weighted according to the market capitalisation of the shares that they represent. By getting a feel for the market capitalisations of the various shares trading in the market, you can begin to distinguish between large blue-chips and small “penny stocks”. So, for example, Naspers had a market capitalisation of around R1368bn, while Pick 'n Pay had a market capitalisation of around R26,5bn (16-11-20).

 

DIVIDEND COVER

 

This is the number of times that the dividend is “covered” in the earnings. In other words, how many times could the dividend have been taken out of the earnings. In our example, this would be:

 

Dividend Cover = Earnings / Dividend = R1.5m / R0.5m = 3

 

The dividend cover is usually determined by the company’s “dividend policy” which is set by the board of directors. Blue-chip shares generally have a dividend cover of between 2 and 5 times depending on how conservative they are. Obviously, investors want some return on their investment, especially once the company is a well-established business and has surplus cash. Growth companies tend to pay lower dividends or even no dividends at all because they want to plough as much money as possible back into the business.

 

RETAINED INCOME

 

This is that part of the earnings that is left in the company after the dividend has been paid out. This is the money which the directors are ploughing back into the business to assist future growth. In our example,

 

Retained Earnings = Earnings – Dividend = R1,5m – R0,5m = R1m

 

These eight ratios are commonly used and referred to in the financial press, so it is very important for you to be thoroughly familiar with them.

 

Three of them can be charted on your software for any share or index. The chart below shows Standard Bank’s share price in the top half of the chart and its dividend yield (DY) in the bottom from September 2015 to November 2020:

You can see here that for a short while in January 2016, Standard Bank’s DY was above 5%. This is situation is very rare in normal markets for a well-established blue chip like Standard Bank – and it generally represents a great buying opportunity – as it did in this case.

Much later in 2020, the company’s dividend yield soared to over 9,4% because of the COVID-19 pandemic and the subsequent lockdown. Obviously, COVID-19 was a “black swan” event which was unpredictable and completely unrelated to the economic circumstances of the time. Technical analysts call this a “technical aberration”, but for the brave it presented a great buying opportunity. Standard Bank shares plummeted and for a brief time were available at bargain prices.

To display the yields in your software,  click on the right mouse button and select “Yields” from the right mouse menu. You will then have the choice of displaying the DY, EY or P:E for that share.

 

GLOSSARY TERMS:

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