No matter whether you’re an established investor or investing in equities for the first time, the goal remains the same: to maximise the return on your investments.
Whether you are saving for retirement, for educating children or for an overseas holiday, ultimately you’d like to grow your savings as quickly as possible.
Where do you start? If you’re going it alone and want to build up your own portfolio of individual shares, then you must play the role of fund manager, and you’ll need to learn how to pick the shares offering the best value in the stock market.
The choice of which shares to buy depends on the company’s valuation. Yet how you value a company will vary, depending on the type of company as well as your own level of investment knowledge.
Traditionally, investment methods have been divided between either growth or value-style investing. For growth investors, the most important factor to consider is a company’s ability to grow its earnings at a rate consistently ahead of its peer group, while value investors consider more crucial a company’s tangible net asset value (the value of the sum of its parts), and the sustainability of cash flows that allow it to pay dividends and service debt.
However, a large number of investors may not look specifically to either the growth or value method but prefer to use a combination of these techniques.
There are a host of valuation methods to choose from, but the most popular include a company’s share price to earnings ratio (PE ratio), its PE ratio relative to earnings growth (PEG ratio), dividend yield, free cash flow, net asset value, or, in specific instances such as insurance companies, the embedded value (EV) of the company.
It is important to remember that the value inherent in any company will always be benchmarked against its peers to give it a relative rating. Hence, a company listed on the JSE in the food sector will be compared to its peers in that sector, and, in turn, its value may be compared to the value of the market as a whole.
Let’s take a look at some of the better-known valuation methods:
PE ratio
A starting point for all investors is the classic price:earnings ratio, which is the price of a share on any given day divided by the company’s annual earnings. As a general guide, the lower the ratio, the more inherent value there may be in a share, owing to either a low share price or high earnings.
Consider a company with a PE of five versus one with a PE of 10. The ratio means the first would take five years’ worth of earnings for the company to repay the investor the price paid for the share, versus 10 years in the second instance (given a constant share price). Hence, the higher its earnings growth, the faster it can pay back your initial investment.
It follows that market analysts will look at the expected (forward) earnings of companies against historical earnings to get a better idea of where the company might be headed in the future. As a result, they talk about a forward PE ratio. Simply put, analysts like to forecast what a company’s future growth is likely to be as it is an indicator of both its present and future value.
Thus, a future PE that is becoming lower over time is an expression of growing earnings and superior prospects (given a stable share price).
Dividend yield
Investors and analysts place a lot of emphasis on the quality of earnings as an indicator of a company’s financial health. A high dividend yield (expressed by dividends as a percentage of earnings) is a good indicator of a company’s ability to service debt and to return excess cash to its shareholders.
Consistency of, and growth in, the dividend paid to shareholders is a sign that a company is generating good, consistent profits, while also providing a measure of its financial health.
Free cash flow
Also important is the ability to generate a profit, so it stands to reason that a better understanding of a company’s cash flow will give a potential investor additional insight into the group’s financial well-being.
Free cash flow is the most common method of analysing this — it indicates how much cash is left over after a company has paid expenses, including dividends, working capital requirements and capital expenditure. A company with strong, consistent cash flows attracts a higher value. A free cash flow analysis would have kept many investors out of dotcom companies in the late 1990s.
PEG ratio and growth
Growth investors will not be influenced by dividend yields and net asset values. Rather, management ability, gearing (the ability to generate superior profits from borrowed funds) and future prospects are most often the key criteria to growth investors. A high PE ratio will not necessarily be a deterrent to growth investors, as long as the PEG ratio is lower than its peer group, indicating relatively high earnings growth.
Value investing
Value investors, meanwhile, seek low levels of debt and long-term sustainability of the markets in which the companies operate. Low PE ratios and high dividend yields are normally characteristics of value-style investing.
Given that accurate crystal balls are in short supply, the above methods are some of the best predictors of a company’s future value. They will certainly assist in selecting shares that could prove to be good investments going forward.
Gavin Cawse is a stockbroker at BoE Private Clients