When it comes to understanding sharemarkets there is so much to learn. Sir Isaac Newton was swept up in the South Sea Bubble and reportedly said afterwards, “I can calculate the movement of the stars, but not the madness of men”.
But calculate we must, unless we are using a methodology such as momentum to buy and sell stocks, otherwise how does one value what we are buying?
So what is this P/E multiple?
It is in simple terms, the price you pay for the share, as a multiple of the net earnings per share (EPS) of the company. If a company share is priced at $5.00 and the earnings per share is 50 cents, then we are paying a 10 times multiple. Or, put differently a PE of 10x.
Note that Earnings Per Share (EPS) is different to Dividend Per Share (DPS).
In the case we just used, the $5.00 share may have earned 50 cents for the last year, but is only paying out 25 cents (DPS).
Understanding the dividends per share, and the earnings per share helps us to work out how much income the company is generating for us. These two metrics are called Earnings Yield and Dividend Yield.
The dividend yield is the DPS/Share Price. In our example, $0.25/$5.00 = 5.00% income paid out to you on your investment. (Eat money as one of our clients calls it)
The earnings yield is the EPS/Share Price. This calculation is $0.50/$5.00 = 10.00% This is what you are actually earning on your investment, even though the company is holding some of the earnings back for future growth.
While many focus on the dividend yield, the earnings yield is probably more important. A company that pays out 100% of its earnings as dividends may have nothing left to re-invest in growing the company.
The calculations for a PE ratio can be done on a trailing (actual) earnings, and also a prospective, or expected future earnings basis. The trailing is often called Last Twelve Months (LTM) or Trailing Twelve Months (TTM) while the prospective expected forward looking figure is called Next Twelve Months (NTM).
Let’s take this to a real life example, the supermarket operator Coles, recently demerged from Wesfarmers.
For the year ending 30 June 2020 Coles made a profit after tax of $978,000,000 and paid out dividends of $873,000,000. The total number of shares on issue was 1,334,000,000.
When we divide $978,000,000 / 1,334,000,000 we get $0.733 earnings per share (EPS).
When we divide the dividend payout amongst the shareholders ($873,000,000/1,334,000,000) we get $0.654 dividend per share.
When we look at where the share price of Coles is trading today, we are able to calculate both the EPS and the DPS as percentage return on investment. (TTM not NTM)
The Coles share price of $17.98 (Dec 4, 2020) gives us a dividend yield of 3.63% ($0.654/$17.98) and an earnings yield of 4.07% ($0.733/$17.98)
In other words, when we invest $10,000 today into Coles shares, we are earning 4.07% (business) profit on the investment. Of that, we are taking away 3.63% in (dividend) profit.
Our actual total return will be a function of dividends received, and changes in share price over time. As you can see, the former is relatively easy to calculate, the latter is what Sir Isaac Newton was unable to compute!
The other topic of this post is the term Market Capitalisation.
Market Capitalisation would be more logically referred to as Total Market Value or TMV. But the term Market Capitalisation, or Market Cap for short is the term that has developed over the years.
It is the market price of a single share in the company on a given day, multiplied by the number of shares on issue. Using our previous example, the ‘market cap’ of Coles was $23,985,000,000 on December 4 2020 ($17.98 price x 1,334,000,000 shares on issue).
Why is market cap important? Well, it helps us with the Warren Buffett concept of thinking like you own or are buying the whole business.
It helps get some perspective on whether a share price is justified when we know the whole market value of the company that is being ascribed to that share price.
A small penny stock that jumps from $0.01 to $0.02 just increased by 100%. But what is its market cap, and would you buy the whole company at that price? Some of these small companies might have a billion shares or more on issue. A billion shares times $0.02 = $20 million value. Does a company that just posted some promising news on an increase in revenue justify its value moving from $10 million to $20 million? This is the best way to look at and evaluate a change in price. What am I paying for this whole company? Has the market cap movement really been justified?
While this is just the tip of the iceberg in understanding share valuations, it is an important starting point to share market ‘investing’. Investing without knowing these things is speculating, and while systemised momentum strategies may not require you to know the fundamentals, if you are not following a strict trend following momentum system, you have better learn all you can about fundamentals!
Mark,
As always – thank you for the reference material – good reading.
If you care to look further into the battery storage world you will find a proponent of FLOW BATTERIES in the west which part of the AVL (ASX) group.
For service benefits that they promote their technology is around vanadium – which is seen as a perhaps an alternative to the lithium batteries.
AVL being in the running for a NAIF loan in this years bidding.
Take care and lets catch up soon.
Russell Loane
Thanks for the comments Russell, I do hold some AVL as well thanks to you. I also reviewed some of their recent announcements which are looking very promising. And co-incidentally another of my contacts who is building data centres right now also confirmed they will be using Vanadium Redox for power storage.