Yield and price/earnings ratio (P/E)

Yield and price/earnings ratio (P/E)

Yield represents the historical annual dividend income paid by the share as a percentage of its current price. P/E shows how many years of current earnings are represented in the current price. Both of these ratios will therefore fluctuate with the price of the share - P/E in direct proportion and yield in inverse proportion.

These are the two most common ratios used by investors and market commentators in evaluating a share as a potential investment, both on its own merits and as a comparison with other shares. For this reason they are widely quoted in the press and almost every serious newspaper will show these figures alongside the price of each share in the listings.


COMMON MISTAKES

1. Believing that share price alone is an indication of the value fo the share

It seems logical to believe that shares for company A, with a share price of $200, are twice as expensive as those of company B, with a share price of $100. This is completely incorrect. The share price alone tells you almost nothing about the share, which is why P/E is so critically important.

Suppose in the above example, A has a P/E of 12 and B a P/E of 24. Now you can see that in fact B is twice as dear as A, even though it has half the share price. It means that collectively, investors have decided that it is worth paying 24 years' earnings for B but only 12 years' earnings for A. This does not mean that the collective market view is right or wrong, in that a higher P/E is better or worse than a lower one. That is a matter for the individual to decide for him- or herself.

What we are doing when using P/E is relating the price to some other fact about the company, in this case to earnings. Similarly, yield relates the price to the annual dividends paid. There are several other measures that relate the price to something about the share, examples, being assets (P/B) and sales (P/S). It is really only by reference to these that one share can be compared with another to ascertain which is cheaper or dearer.

2. Thinking that the yield will apply in future

In most cases, the yield figures shown in papers are historical. The exact method varies between papers, but generally it is based on taking the last year's dividends paid, dividing by the share price, and expressing the result as a percentage. But it must be borne in mind that no company is obliged to pay dividends at all.

3. Assuming that yield figures will always be sustainable

If you look through the tables, you can occasionally discover shares that appear to give enormous yields like 20% - which, on the face of it, seems to be a fantastic investment. But if you look behind the figures at announcements from the company, you will very likely find that it is going through a bad time and will probably cut, or eliminate, its dividend in the future. The huge historical yield appears only becasue the share price has collapsed following the bad news, and a falling share price drives up the yield in inverse proportion. so do not make the mistake of assuming that the yeild figures are always sustainable in the future, particularly those that appear astronomically high in relation to the rest of the market.

Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)