Generally speaking, investors want to buy shares at prices below their “true value”, because that way the chance of a fall is less and the opportunity for making a capital gain is enhanced. Gains can come about both if the share price then rises towards to its “true value” and as the “true value” itself rises.
In the meantime a share acquired at below its “true value” would show a higher annual return than if it had been acquired at its “true value”.
As between the shares of different companies, clearly the ones available at the highest proportionate discount to the corresponding “true values” would constitute the greatest bargains, the best “value for money”.
The most useful approach to estimating the “true value” of a share involves a two-step process. It is to apply an appropriate price earnings (PE) ratio to an appropriate earnings per share figure.
A suitable PE ratio for a company can be obtained by looking at the ratios applying to the shares of its competitors and to the shares of other comparable companies. The PE ratio is the market value of a share divided by its earnings per share.
Other things being equal, the lower the PE ratio the better the value inherent in a transaction for a purchaser. However, things are never equal and some apparent bargains may be quite illusory. Distortions can arise from the mechanical nature of the arithmetic. Investors are much more interested in the future than in the past – and market prices reflect such expectations.
Dividing a current market value by the last published earnings figure can produce a nonsense result, especially if losses or significantly reduced profits for subsequent years are now expected.
Just before a new annual report is due the available full year data will normally refer to a period which ended about 15 months earlier and which commenced 12 months before that, in other words 27 months ago, perhaps under very different conditions.
To obtain a hypothetical market value for a share the PE ratio as ascertained in the above way is then multiplied by the prospective earnings per share figure for the current year (or for some other year in the near future, possibly with some allowance for the delay).
Another, but less useful, approach to estimating the “true value” of a share is to divide the prospective dividends per share figure by an appropriate dividend yield. The reason that it is less useful than the approach based on earnings referred to above is that ordinary shareholders have an equity (or stake) in all earnings, whether these are being distributed or not. Furthermore, the payout ratio depends on an arbitrary decision by the directors of the company.
However, as demonstrated by the discussion of the recent T3 issue, many investors pay considerable attention to the dividend yield and this means that it cannot reasonably be ignored, despite its theoretical limitations. Other things being equal, the higher the yield the better the value for a purchaser.
A suitable dividend yield for a company can be obtained by looking at the yields applying to the shares of its competitors and to the shares of other comparable companies. In each case the yield is the dividend per share divided by the market price, expressed as a percentage.
The warnings set out above should, however, again be borne in mind. Furthermore, regard should be had to the franking status of the dividends. The dividend yields from companies paying fully franked dividends are not really comparable with the dividend yields from companies paying unfranked dividends.
On this approach to obtain a hypothetical market value for a share this yield is then divided into the prospective dividend per share figure for the current year (or for some other year in the near future, possibly with some allowance for the delay).
The prospective dividend per share figure for the current year for the purpose of this arithmetic would be based on the rate for the previous year, subject to any later information provided by the company. Companies making new issues are expected to indicate the likely new dividend rate in future.