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A public traded company exists to make a return to stakeholders. This week’s article examines how to use earning in the individual stock selection process

First, the use of earning (profits) is in determining the Price Earnings Ratio

The P/E ratio divides a stock’s share price by its earning per share to come up with a value that represents how much investors are willing to shell out for each naira of a company’s earnings. If the stock price is N50 and the earning per share is 10, the PE Ratio is 50/10 or 5.

The P/E ratio allows an investor to determine how much of current earning is being paid for at the market price of the stock. In our example, at the market price of N50, if that share is bought, the investor is paying five times the earning of the company, i.e. a multiple is 5. The PE also tells you how long you will have to wait to receive your investment back.

Again, from our example, a N50 investment at the current level of earning will be repaid in 5 years. Every investor must understand what the PE is saying in relation to the relative cost of the individual share or index. If Share A with a market price of N100 has a PE of 10 and Share B with a market price of N50 has a PE of 30, Share A is “cheaper’ (than Share B because the investor is paying less – 10 times current earnings)  to participate in the future earning of the stock.

Keep in mind, to compare PE of stocks in the same sector, i.e. a bank stock should be compared to another bank PE ratio. This is because different industries post different earning stories in their sectors. Take information technology, most companies in their space can have years of initial zero earning (Facebook).

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We can also use earnings to get the target price of a share

Remember a share represents the investor’s share of a company’s declared profits for life. Assuming the risk-free rate is 8%, thus we can use earning declared as follows:

  • Get the risk-free rate that corresponds to how long you want to hold the individual stock e.g. if the investor intends to stay invested for a year, and FGN Bond for one year returns 8%.
  • Get the earnings per share of the share you want to buy, it’s usually published in most business papers, let’s assume EPS is N2,00.
  • Divide 100 by the risk-free rate, eg 100 divided by risk-free of 8% for a year is 12.5.
  • Multiply the answer in ‘3’ by the Earnings per Share, eg 12.5 x N2 equals N25.

This means that by earnings, the price of the share should be N25 because if the investor places N25 in an FGN Treasury-Certificate paying 8% the return will get N2.00.

If the price is above N25, it simply means the market price is above your valuation. As an investor, you want to invest where the market price is below your valuations, giving you a “margin of safety” between your valuation and the market.

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Using Dividend Yield

Our final example will use the dividend yield to create a selection of stock to invest in by declared earning expressed as dividends. This approach is called the Dividend Yield Method. It gives the investor a disciplined method to invest in the stock market. Let me give you the steps.

Dividend is the declared dividend divided by the market price of the stock.

Again, we have a step by step process.

  • Get the yield of the 1-year Government Bond. Also, get the yield on the NSE All-Share Index. If the yield on the Govt bond is higher then, don’t invest in shares, simply invest in the govt bond. Why? It’s a higher yield, risk-free.
  • If the yield of the NSE ASI is higher, get the top 40 stocks in the NSE, ranked in order of dividend yields.
  • Select the top ten ranked stocks by dividend yield, eliminate the rest. Rank selected stocks in order of lowest price to the highest price.
  • Buy from the top listed stocks to the lowest, i.e. buy stock with the lowest price and highest dividend yield. Dividend yield method allows you to invest in good value stock when they are out of favour. i.e. buying low.

Revenue Reserves and Dividends, Using Earnings to Select Stocks

The final point about investing in shares

  • Get advice.
  • Buy what you know. If you don’t know how a company makes money, don’t invest in the stock.
  • Favour stocks with low PE ratio, not just lower prices. This means you are buying a stock at a lower multiple
  • The profit on trading in stocks is made when the stock is bought, so buy a stock at a big margin between intrinsic value and market price.

Remember, past performance is not a guarantee of future performance, always speak to your financial adviser before investing. Investing in shares is risky.

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