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Cards or shares? Demystifying PERs

Cards or shares? Demystifying PERs:Batanai Matsika

ONE Friday night Piggy took some time to visit one of the largest casinos in the country. As expected, he was alarmed by the scores of people that gathered there. Getting parking was a big struggle as the venue was extremely packed.

As Piggy entered and walked into the main casino area, he felt like he had stepped into a trading floor on the New York Stock Exchange (NYSE). The atmosphere was charged, every player was focused on the poker machines and overhead screens where displaying the sums of money that had been won in the previous weeks and months — in millions. Meanwhile, others were busy on the poker tables, rolling the dice.

While most people would like to think of it as entertainment, one observation made by Piggy was that there was something more than just the games. Everyone in the room had a drive and passion to win and most importantly, they all trusted that the poker machines were programmed to give everyone a fair chance or probability of winning.

Of course, there is an element of excitement when it comes to betting in general. That said, the same can also be said of stock market trading given the fact that traders have the potential to experience the rewards of successful investment and trading decisions. Most people think that one needs an Economics or Finance degree in order to trade or invest in shares on stock markets.

However, the truth is that any person, with extensive or very little trading or investing experience, can trade shares successfully. For example, the latest global news headlines have been on the upcoming United States presidential elections. The trading and investing game is simple — all you need is to follow the markets and act on the right information. Through online share trading, retail investors can now have direct market access (DMA) on global stock markets such as the JSE and NYSE.

In Zimbabwe, exciting developments have taken place, and these include the introduction of ZSE-direct and C-Trade. These are home-grown solutions that enable anyone to access Zimbabwean stock markets in real time from anywhere, anytime using everyday basic gadgets.

These platforms benefit investors in that they bring efficiency in the stock market as it allows anyone — be it the formally employed or those in the informal sector to become shareholders in companies of their choices anytime from anywhere. The platforms also give Zimbabweans in the diaspora a chance to invest in shares with enhanced simplicity without asking anyone home to do it for them. They can even monitor their portfolios in real time!

While the stock market represents a massive opportunity for participants, it is very different from poker games. Investors will have to do some work in terms of identifying what to buy or sell. As a follower of the stock market, you most likely might have heard analysts or commentators referring to what are called price-earnings ratios (PER).

In this article, Piggy would like to demystify PER ratios and also educate folks on how they can make use of this metric to pick stocks on the market

PER is a simple multiple that compares the current share price to the most recently reported earnings per share. This is usually referred to as the historic
PER and considers full-year earnings. The time period involved is not the same for each side. Current price is today’s known price, but earnings may be weeks or months out of date. In other words, price per share is a technical signal and the value of earnings per share is fundamental.

PERs, therefore, combine a technical value (price) with a fundamental value (earnings) and each side applies to a different time period.

In essence, the PER indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. This is why the PER is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was currently trading at a PER of 30x, the interpretation is that an investor is willing to pay $30 for $1 of current earnings.

The most important issue is how one makes use of PERs to make decisions on the stock market. As a general rule, the PER is considered moderate when it is found between 10x and 25x. Below that, there may be a lack of interest among investors; above that, the stock might be overpriced. A low PER could point to not just a lack of interest but a real bargain priced stock. High PER is not always an overpriced stock but could be one that has greater than average potential for future growth.

It is worth noting that a single PER does not reveal much about the trend over time and cannot be relied upon for any accurate conclusions. Piggy recommends that one uses the PER as a comparative tool when considering companies in the same sector.

Comparing the PER of a telecommunications and a food company, for example, may lead to inaccurate conclusions. Generally, companies with lower PERs than their peers are more attractive. A variation to this is called forward PER. This is based on an estimate of future earnings per share. The problem with using estimates is that the result lacks reliability. The forward PER provides some benefit for analysts but the conclusions drawn depend on whose earnings estimate is used.

Piggy also recommends using Earnings Yield for Stock Picking. The Earnings Yield is an inverse of the PER ratio and shows the percentage of how much a company earned per share. It is a useful metric to determine which assets seem underpriced or overpriced. The metric is calculated by dividing earnings per share for the most recent 12-month period by the current market price per share.

The most common practice is to compare the Earnings Yield of a broad market index (such as the ZSE All-Share Index) to prevailing interest rates, such as the current Treasury yields. If the earnings yield is less than the rate of the treasury yield, stocks as a whole may be considered overvalued. If the earnings yield is higher, stocks may be considered undervalued relative to fixed income instruments.

This approach is relevant given that investors in equities should demand an extra risk premium of several percentage points above prevailing risk-free rates (such as rates on Treasury Bills) in their earnings yield to compensate them for the higher risk of owning stocks.

As a general rule, a low ratio may indicate an overvalued stock while a high value may indicate an undervalued stock. It is also important to consider growth prospects for a company when using Earnings Yield. Stocks with high growth potential are typically higher valued and thus may have a low Earnings Yield even as their stock prices are rising.

Overall, one approach that can enable traders to remain updated with all developments on the stock market is social trading. This is the newest trend in financial markets trading where people can connect, interact, discuss and profit in a community trading environment.

Social trading: (i) enables traders to receive real-time alerts on-the-go for important economic events and obtain the latest fundamental or technical commentaries; (ii) necessitates information-sharing/knowledge transfer and (iii) less experienced traders can benefit by following the trades of more experienced traders.

While a number of applications have been developed to enable social trading, social media and messaging platforms with live chat capabilities can be used for the same purpose.

Piggy has embarked on campaigns aimed at increasing the participation of individuals on Zimbabwe capital markets through WhatsApp-based social trading groups. WhatsApp provides a perfect platform to create social trading groups whereby a group of traders can coordinate themselves and share information as well as trading ideas or strategies.

This new trend is very beneficial and can be used by new traders that would like to connect and receive ideas directly from other trading teams. So, the big question in our minds is: where would you put your hard-earned money? In cards or shares?

Matsika is an equities analyst, head of research at Morgan & Co and founder of piggybankadvisor.com. — batanai@morganzim.com/ batanai@piggybankadvisor.com or mobile +263 783 584 745.

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