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PE ratios and earnings yield

BY BATANAI MATSIKA

Piggy’s Trading & Investing Tips

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

The Price Earnings Ratio (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 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 Current price is today’s known price but earnings may be weeks or months out of date.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 period.

In essence, the PER indicates the dollar amount an investor can expect to invest in a company 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 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 the 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. A good example has been the financial services sector in Zimbabwe. A re-rating occurred when new owners came into CBZ Holdings. As a result, valuation multiples for CBZH (Fwd PER of 79.9x) imply that the counter has clearly rallied ahead of fundamentals. While Piggy notes the improved risk profile since the exemption of the OFAC fine, the counter now holds minimal upside at this stage. However, a re-rating should be expected in peers such as ZB Financial Holdings and First Mutual Holdings Limited. Piggy thinks investors should be switching out of CBZ Holdings and buying into other financial services stocks.

Investment Tip:

Using Earnings Yield for Stock Picking

Piggy believes that “The time is Stock’o Clock”, meaning that it is a good time to take positions in shares on the Zimbabwe Stock Exchange (ZSE) and Financial Securities Exchange (Finsec). Piggy also recommends using Earnings Yield for Stock Picking. The Earnings Yield is an inverse of the PER and shows the percentage of how much a company earned per share. It is a useful metric to determine which assets seem under-priced or over-priced. The metric is calculated by dividing earnings per share for the most recent 12-month period by the current market price per share as shown below;

The most common practice is to compare the Earnings Yield of a broad market index (such as the ZSE ASI) to prevailing interest rates, such as the current Treasury yields.

If the Earnings Yield is less than the rate of the Treasury Yield, stocks 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 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.

It is also worth noting that sometimes investments with strong valuations and high PE ratios might generate more earnings over time and eventually boost up their Earnings Yield. This is what growth investors are looking for. On the other hand, investments with weak valuations and low PE ratios might generate less earnings over time and, in the end, drag down their Earnings Yield.

Earnings Yield may also be useful in a stock that is older and has more consistent earnings. Growth is expected to be low for the foreseeable future, so the earnings yield can be used to determine when it is a good time to buy the stock in its cycle. A higher-than-normal Earnings Yield indicates the stock may be oversold and could be due for a bounce. This assumes nothing negative has happened with the company. For more information on stock picking methods, visit www.piggybankadvisor.com

Matsika is the 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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