MARKET RATING
In the previous module you learned about 8 important relationships which are commonly used to evaluate the performance of shares and sectors in the market. The most important of these are the reciprocal relationships of the earnings yield (EY) and the price:earnings ratio (P:E) – because these give you the connection between a company’s share price and its profitability.
When you buy a share, you are looking for a company that will rise in price over time so that you can make a solid capital gain. The price of a share only rises when investors as a group believe that the company will produce better profits and dividends in the future. If they believe this, they will buy the share up causing the price to rise (and vice versa).
So, the question you need to ask about a share is,
“Is it cheap or expensive in relation to its earnings potential?”
One way to evaluate that is to look at its earnings multiple or P:E ratio. As you have seen in the previous lecture, a company’s P:E can be easily calculated by dividing its share price by its most recent annual earnings per share (EPS). In effect, that will give you the number of years it would take you as an investor to recover what you paid for the share out of its earnings – assuming that those earnings remain at the same level as they were in the most recent accounting period.
So, for example, if a company has a P:E ratio of 10 then it is trading at ten times its most recent year’s EPS. A company trading on a P:E of 15 would cost you 50% more for the same EPS. The only reason that companies trade on different P:E ratios is because investors consider their future flow of earnings to be more or less reliable. And that is usually based on what they have done in the past. So a company with an erratic earnings track record will tend to trade on a much lower P:E than one with a very consistent EPS pattern. The best shares are those which have an EPS which has been rising at a steady rate (like 15% per annum) for many years. These are called “blue chips” and are “highly rated” by investors.
Of course, when a share is highly rated because of its earnings track record, investors buy the share and bid its price up to much higher levels – which means that its P:E will also increase, making it more and more “expensive” in relation to its earnings flow.
So, you will often see financial journalists writing about a share’s “market rating” based on earnings figures. The “market rating” is an informal process based on the end result of the free play of market forces. There is no body or authority that assigns a rating to shares on a monthly basis!
P:E ratios and “market ratings” often seem confusing to the beginner. At first glance, shares with very high multiples seem the least attractive because they are the most expensive, yet they will be described as “highly rated”. Others with a very low multiple will be considered “poorly rated”. But the multiple reflects the company’s market rating so highly rated shares will inevitably also have high P:E multiples – and vice versa.
EARNINGS YIELDS AND INTEREST RATES
The earnings yield, which is the inverse of the P:E ratio, can be loosely likened to the interest rate received on bank deposits and savings accounts. It is an error, however, to simply compare the earnings yield (EY) as quoted in the paper with the current interest rates available to see which is the better investment.
The reason that interest rates cannot be compared directly with earnings yields is that interest rates are what will be paid in the future whereas the earnings yield is what has been paid in the past. This is an extremely important distinction. If a bank accepts a fixed deposit at 10%, they are undertaking to pay 10% per annum interest on your money in the future. If a share is trading at a 10% EY, however, this does not mean that the share’s earnings for the coming year are going to be 10%. It simply means that the most recent available earnings figures (which will already be considerably out of date) represent 10% of the current share price.
The only time we could compare earnings yields directly with interest rates would be if we estimated or guessed what a company’s profits in the coming year were going to be. In other words, we might estimate that this year’s EPS was such that the share was trading on a forward EY of 10% of the current share price. But, of course, the value of that would depend on how accurate our estimate was.
There is another flaw in the comparison of a share’s earnings yield with the interest rate available from a bank. Your investment with the bank has no potential for capital gain, so the interest rate is all that you will get. A share, on the other hand, can easily provide you with both a dividend and a capital gain. To make the comparison realistic you would need to work with the total return from the share (i.e. capital gain plus dividend in an annualised form).
HISTORICAL AND FUTURE PROFITS
The problem with earnings yields, then, is that they are calculated from historical profits. These are of far less importance in determining a share’s price than what the market thinks current profits or future profits are likely to be.
The “market rating” that we are talking about really reflects what the market thinks of a company’s future profit potential. If the market thinks that profits in coming years are going to exceed previous year’s profits, investors will be willing to pay more for the share in relation to past earnings. If investors think that profits are going to decline, the share will look cheap in terms of its past performance.
It should also be clear from the above that the earnings yield is a dynamic rather than a constant figure. This is because, while the historical earnings are relatively fixed (they only change once every six months when the interim or final financial statements are released). The share price, on the other hand, is usually subject to daily fluctuations as the opinions of investors regarding its future earnings change constantly. Each time the share price changes, the earnings yield will be adjusted automatically. If the price goes up, the earnings yield will fall. If the price goes down, the earnings yield will go up. (The P:E ratio, which is simply a reciprocal of the earnings yield, will of course behave in exactly the opposite fashion).
In conclusion, therefore, we can say that a highly-rated share is one with a low earnings yield (and a high P:E ratio), and a poorly-rated share is one with a high earnings yield (and a low P:E ratio). The paradoxical nature of earnings yields is that, on the face of it, the share with the highest EY looks the most attractive, but it would be described as “poorly-rated” – because its EY reflects what has happened rather than what is going to happen. But poorly rated shares should not necessarily be ignored. On the contrary – a high EY might indicate a share that has become heavily undervalued and is therefore a bargain. The fact of the matter is that highly rated shares are often overpriced and vice versa. Rubbish can be cheap, and quality can be expensive. Your job, as a private investor, is to find and buy shares when they are cheap and sell them when they are expensive.
TARGETING HIGH EARNINGS GROWTH COMPANIES
One would expect companies which grow their earnings faster than others to enjoy a superior share price growth.
Take a look at the following table of JSE listed companies’ shares, earnings and prices over an eight-year period:
| Share Price Year 1 | Share Price Year 8 | Over 8 Years EPS% Growth | Over 8 Years Price % Growth | |
| 1 | 5970 | 12350 | 212.9 | 106.9 |
| 2 | 445 | 9900 | 813.9 | 2124.7 |
| 3 | 1188 | 3200 | 106.0 | 169.4 |
| 4 | 9965 | 41940 | 338.8 | 320.9 |
| 5 | 2500 | 10140 | 193.7 | 305.6 |
| 6 | 1070 | 3740 | 225.2 | 249.5 |
| 7 | 4950 | 34500 | 249.0 | 597.0 |
As you can see, EPS growth and share price growth are not always in line. For example, Company 1 grew EPS by 212,9% and yet its share price went up by only 106.9% (from 5970c to 12350c). This may be because investors are concerned that the profits will prove to be unsustainable in the future. Alternatively, it could indicate that Company 1 was relatively expensive at the start of the 8 years. Company 2, on the other hand, grew earnings by just over 800% but saw its share price rise by a whopping 2124.7% (from 445c to 9900c). This shows the huge enthusiasm which investors had for that particular share and industry in SA over this 8-year period. It is useful and interesting to study the relationship between EPS growth and share price growth.
Using your software you will find it very easy to do this exercise because the program comes with a database of fundamental comments on all shares on the JSE, including EPS figures for at least the last ten years in most cases. Then there are other sources of information on EPS growth. Each year, Sunday Times, Business Times and Financial Mail and F&T Weekly come out with their “Top Companies” surveys. You should get copies of these and keep them as reference material.
Returning to the above table, you will notice that there does not appear to be a direct correlation between EPS growth and share price growth. Company 3’s EPS has grown by 106% while its share price went up 169% while Company 7 has seen its share price go up by nearly 600% in response to an EPS growth of just less than 250%.
There are many reasons for this. For example:
- The figures which we are using are all historical and take no account of what will happen in the current year or the year after that. Companies which expect to do exceptionally well in the coming financial year will experience a sharper share price appreciation than those who expect merely to repeat last year’s performance.
- A major acquisition can have a material impact on the share price because it adds an entirely new source of earnings for the company. It may also increase the company’s debt and hence its annual finance charges which would negatively impact earnings.
- The compounding of EPS growth over an 8-year period like this may disguise the fact that growth slowed down in the last year or two, and the share price is reflecting this slowdown. Similarly, EPS growth may have picked up in the last two years, but this is disguised by averaging out the growth over the eight years. Companies which show sharply higher earnings growth in more recent years may be expected to continue this rate of growth in the next few years, and investors will be prepared to pay higher prices for such shares.
Commodity shares (such as Company 7) above tend to be more volatile than retailers (like company 6). Companies which are not much affected by the business cycle (like medical shares) are called “defensive” and their shares are generally more highly rated than “cyclical” shares like those in the furniture and motor vehicle industries.
But the general rule is:
HIGH GROWTH COMPANIES EXPERIENCE FASTER SHARE PRICE GROWTH THAN COMPANIES WITH LOW GROWTH
Usually, if a high-quality company’s share price lags behind its EPS growth in one year it will tend to catch up the following year. Of course, the most important factor is consistency of EPS growth over a long period of time. As we have already said, companies whose EPS growth is volatile will be less sought after than those whose earnings grow steadily over many years.
The question that immediately arises is: if blue chip shares like Bidvest, Investec, Standard Bank, Imperial and the other quality shares have already appreciated strongly in price, are they still worth buying?
That depends on the level of the current share price in relation to expected future earnings growth. Investors tend to anticipate or “discount” future events. But a useful guide to the expected future growth in company earnings can be gleaned by looking at the past growth and extrapolating this trend into the future.
In the next module we will explain how you can determine whether or not a share is cheap or expensive at the current price.
GLOSSARY TERMS:
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