HOW TO VALUE SHARES

HOW TO VALUE SHARES

The equity market is fairly capricious and can lead to losses. With care and due judgment in valuing shares, however, substantial profits can be made over and above what can be achieved with relatively less risky securities such as bonds, gilts and bank deposits. ‘Dividend yield’, ‘price earnings (P/E) ratio’ and ‘net asset value’ are the three main tools used in valuing stocks (shares).

Dividend yield gives an indication of the investor’s return for holding the share. It is obtained by dividing dividend per share by the current market price of the share. Dividend per share is the total dividend paid in the most recent twelve months divided by the total outstanding shares. Dividend yield is expressed as a percentage. Let’s assume, for example, the dividend paid by company ‘A’ in the most recent twelve months total £4 million and there are 4 million shares outstanding. Let’s say the current market price of the company is £20. The dividend per share is £4million/4 million, which is £1 per share. The dividend yield will thus be given by (£1 divided by £20) times 100, which is 5%.

This figure 5% means that the investor can expect to earn a return of 5p for every pound he invests in the share.

Traditionally, investors prefer companies with high dividend yields to those with lower ones. A high dividend yield implies that the share is under-priced, and that future dividends will not be higher than previous ones. A low dividend yield, on the contrary, means the share is over-priced and future dividends might be higher.

P/E ratio is a very important ratio for valuing the performance of a share. It is arrived at by dividing the current market price by the earnings per share. For example, if the current market price of a company is £30 and the earnings per share is £5 per share, then the P/E ratio is £30 divided by £5 which is 6. Note that no percentage or unit is attached to the figure. P/E ratio provides two lots of information, primarily. It does give the investor a rough idea of the pay-back period for the amount of money invested in each share. In the example above, for instance, a P/E ratio of 6 informs the investor that it will take 6 years of receiving returns of £5 per share per year, to recoup the £30 used in buying one share. Since there is a lot of variation in the dividends paid by companies over the years, it can be argued that P/E ratios do not provide very accurate pay-back information.

It does, however, provide a fairly accurate view of the growth potential of the share. It portrays the extent to which the market is optimistic about the stock, and its expectation of the share’s future growth. A P/E ratio of 1 means the share is seen with a lot pessimism, whereas a figure of 20 means the share is looked at favourably by investors. Recent research has, nevertheless, shown that shares with low P/E ratios outperform those with high ones. It is perhaps wise to take the middle road, and avoid shares with very low or extremely high P/E ratios.

The shares or units of organisations such as mutual funds and investment companies are valued using ‘net asset value’. This is obtained by subtracting the total liabilities of the firm from its total assets. For instance, if the total assets of the mutual fund is £100 million, and its liabilities, sum up to £10 million, then the net asset value is £100 million minus £10 million, which gives £90 million. The value of each unit or share is then arrived at by dividing the net asset value by the units or shares outstanding. In this example, if there are 2 million units outstanding, the ‘per unit net asset value’ is £90 million divided by 2 million which is £45 per unit. Net asset value as well as per share/unit net asset values are revised daily and published in newspapers.

None of these tools is perfect as a valuation device, but they are definitely superior to just carrying out judgement by speculating. When there is any doubt, moderation should be employed in the choice of the right P/E ratio, dividend yield, or net asset value. It is also advisable to find out the reasons behind the magnitudes of the figures you deal with.

David Opoku

BA Hons.  Accounting and Finance. ( Currently specialising in Financial Advising/Stockbroking in a leading Financial Services company).

E-mail: davido312@aol.com

Web: www.investmentyouneed.com