Cape Town - Is the market cheap or expensive? Is a certain sector overvalued or undervalued? Naspers is trading at over R2 000 per share. Is that expensive? It sure sounds expensive with Steinhoff at just over R80.
It does not necessarily mean that a share with a high price is expensive and those with lower prices are less so. The share that is priced at R2 000 might earn a R1 000 per share for each of their shareholders while the one at R80 or R90 only earns R5 per share.
Below are some of the more common evaluation techniques that might help when valuing shares.
1. Price to Earnings ratio
The Price to Earnings ratio, or PE ratio, is one of the common indicators when valuing shares. Calculating the PE ratio is as easy as taking the price of a share divided by the earnings per share (EPS).
For example, if a share is priced at R100 and EPS is R5, then the share will have a PE ratio of 20. This means at current earnings of R10 per annum, it will take earnings 20 years to pay off the share price.
The PE ratio changes daily as the prices of shares change, as well as annually when companies announce their EPS for the past financial year.
Two of the shares with the highest PE ratio's on the JSE are Naspers [JSE:NPN] with a PE of 120 and Curro [JSE:CUR] with a PE of 200.
Companies like Sasol [JSE:SOL] and Liberty [JSE:LBT], who are currently experiencing some pressure on earnings are trading at a PE of around 8.
2. Dividend yield
The dividend yield is another common valuation technique. A company may decide to distribute some of the profit it made in a year as dividends to shareholders. Again, if a company has a share price of a R100 and declared a dividend of R5 it has a dividend yield of 5%.
It is a worthwhile exercise to compare the dividend yields of companies with the yields on money market accounts and other interest-generating assets.
On face value, it would appear that companies with a higher dividend yield are beneficial but it does not necessarily mean it is a better company.
Companies may very well be in a growth phase in which no dividend gets paid as all earnings are reinvested for future growth.
The South African banking sector is trading on an attractive dividend yield of 4% to 6%.
3. Operating profit margin
The operating profit margin is as much of an efficiency ratio as it is a technique to value shares. The operating profit margin measures how much of the revenue a company generates, is turned into profit.
It is calculated by taking the profit generated and dividing it into the operating revenue generated as a percentage.
The result should be compared to previous years as well as competitors to learn how well a company is turning revenue into profit.
Companies with big labour expenses will have lower profit margins than, for example, IT companies that are not very labour intensive.
4. Price to Book ratio
For all the valuation techniques that are used in valuing a company from its income statement, it is very important for investors to also do balance sheet valuations.
A company's balance sheet will show investors the value of a company’s assets and liabilities.
One of the popular balance sheet valuation techniques is the Price to Book ratio. This gives investors an indication of the price they pay per share if all the liabilities and debt are deducted from the assets.
If a company's share is trading at less than the book value per share, it is believed to offer good value.
A share trading at a discount to book value may be attractive even if the company is not performing efficiently or growing strongly, as investors would receive more than their investment back if the company were acquired or liquidated.
5. Current and quick ratio
The current ratio is a more immediate guide as it measures current assets (convertible into cash within 12 months) divided by current liabilities (with a maturity of 12 months or less).
The quick ratio is an even more immediate measure of financial stability, similar to the current ratio but excludes inventories from the current assets.
The inventory levels get excluded in the calculation of the quick ratio, as it can be difficult for a company to sell their excess inventory at a fair price when they are under pressure or when the market is in over-supply.
* Kirk Swart is an analyst at Overberg Asset Management (OAM), an Authorised Financial Services Provider (No. 783) which specialises in the private management of local and global discretionary portfolios as well as pension products.
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