What determines the returns from stocks?

Very long-run returns from common stocks are driven by two critical factors:

1.  the dividend yield at the time of purchase, and,
2.  the future growth rate of earnings and dividends.

In principle, for the buyer who holds his or her stocks forever, a share of common stock is worth the "present" or "discounted" value of its stream of future dividends.

A stock buyer purchases an ownership interest in a business and hopes to receive a growing stream of dividends.

Even is a company pays very small dividends today and retains most (or even all) of its earnings to reinvest in the business, the investor implicitly assumes that such reinvestment will lead to:

1.  a more rapidly growing stream of dividends in the future or
2.  alternatively to greater earnings that can be used by the company to buy back its stock.

The discounted value of this stream of dividends (or funds returned to shareholders through stock buybacks) can be shown to produce a very simple formula for the long-run total return for either an individual stock or the market as a whole:

LONG-RUN EQUITY RETURN
= INITIAL DIVIDEND YIELD + GROWTH RATE




From 1926 until 2010:

Common stocks provided an average annual rate of return of about 9.8%.
DY for the market as a whole on Jan 1, 1926 was 5%.
The long-run rate of growth of earnings and dividends was also about 5%.
DY + Growth rate gives a close approximation of the actual rate of return.


Over shorter periods

Over shorter periods, such as a year or even several years, a third factor is critical in determining returns.
This factor is the change in valuation relationships, namely, the change in the price-dividend or price-earnings multiple.
[P/Div and P/E tend to move (increase or decrease) in the same direction.]


Ref: A Random Walk Down Wall Street

It is about value, not price

Monday, April 20, 2015

QAF Limited: $1.14 a share is cheaper than 93c a share?

One year ago, when QAF Limited's stock was trading at 93c a share, I observed that the PE ratio was 16.6x and I said that to buy in at that price would be making an assumption that earnings could improve dramatically in the future. There were pertinent concerns such as rising costs of doing business as well as the weak Australian Dollar and how these could continue to weigh down performance.

Well, for the full year 2014, QAF Limited has exceeded expectations as earnings per share (EPS) improved 46.4% from 5.6c to 8.2c, year on year. With the Australian Dollar having weakened further against the Singapore Dollar, how did this happen?

There was a one off contribution by Oxdale Dairy through the sale of its dairy business. Group operating profit, thus, received a boost of $1.6m. This will not be repeated, of course. However, considering the fact that Group profit improved some $15.7m (before tax), not having this one off contribution in the current year would still mean that QAF Limited would do very well, everything else remaining equal.

All business segments did well but the lion share of the improvement came from Rivalea, an Australian business segment. Operating profits improved threefold although revenue stayed flat because of higher selling prices, better product mix, productivity gains and lower raw material costs.

Lower finance costs also helped QAF Limited to do better in 2014 as borrowings were pared down. Interest expense decreased $0.9m from $4.1m to $3.2m last year.

Today, QAF Limited's stock closed at $1.14 a share and based on an EPS of 8.2c, we are looking at a PE ratio of some 14x. Even if we remove the one off divestment gain by Oxdale Dairy, we would be looking at a PE ratio of 14.5x, thereabouts.

So, although QAF Limited's stock is priced higher now, compared to buying at 93c a share a year ago, it is actually cheaper at $1.14 a share. This is what I meant when I said that a stock could actually be cheaper although its price could be higher. It is about value, not price.



Read more here:
http://singaporeanstocksinvestor.blogspot.com/

http://singaporeanstocksinvestor.blogspot.com/2015/04/qaf-limited-114-share-is-cheaper-than.html



Comments:

1.  Price is different from value.  At price of 93 c a share, its PE was 16.6x.  At $1.14 a share, its PE was 14x.  Thus, though the price per share is higher, you are actually paying a lower multiple for its earnings.

2.  For the same reason, a $25 per share company maybe a cheaper buy than a 25 c per share company.  Compare their PEs.

Evaluating a Stock

HOW-TO GUIDE HOME
INVESTING

Evaluating a Stock

Main points:

The most common measure of a stock is the price/earnings, or P/E ratio, which takes the share price and divides it by a company's annual net income.

Generally, stocks with P/Es higher than the broader market P/E are considered expensive, while lower-P/E stocks are considered not so expensive.

Don't automatically go for stocks with low P/Es simply because they are cheaper. Cheap stocks aren't always good stocks.


The following is adapted from “The Complete Money and Investing Guidebook” by Dave Kansas.

In assessing investments such as stock, investors consider the stock’s valuation, strategy, plans for diversification and appetite for risk. Stocks are evaluated in many ways, and most of the common measuring sticks are easily available online or in the print and online versions of The Wall Street Journal.

The most basic measure of a stock’s worth involves that company’s earnings. When you buy a stock, you’re acquiring a piece of the company, so profitability is an important consideration. Imagine buying a store. Before deciding how much to spend, you want to know how much money that store makes. If it makes a lot, you’ll have to pay more to acquire it. Now imagine dividing the store into a thousand ownership pieces. These pieces are similar to stock shares, in the sense that you are acquiring a piece of the business, rather than the whole thing.

The business can pay you for your ownership stake in several ways. It can give you a portion of the profits, which for shareholders comes in the form of a periodic dividend. It can continue to expand the business, reinvesting money earned to increase profitability and raise the overall value of the business. In such cases, a more valuable business makes each piece, or share, of the business more valuable. In such a scenario, the more valuable share merits a higher price, giving the share’s owner capital appreciation, also known as a rising stock price.

Not every company pays a dividend. In fact, many fast-growing companies prefer to reinvest their cash rather than pay a dividend. Large, steadier companies are more likely to pay a dividend than are their smaller, more volatile counterparts.

The most common measure for stocks is the price to earnings ratio, known as the P/E. This measure, available in stock tables, takes the share price and divides it by a company’s annual net income. So a stock trading for $20 and boasting annual net income of $2 a share would have a price/earnings ratio, or P/E, of 10. Market experts disagree about what constitutes a cheap or expensive stock. Historically, stocks have averaged a P/E in the mid teens, though in recent years, the market P/E has been higher, often nearer to 20. As a general rule of thumb, stocks with P/Es higher than the broader market P/E are considered expensive, while stocks with a below-market P/E are considered cheaper.

But P/Es aren’t a perfect measure. A company that is small and growing fast may have a very high P/E, because it may earns little but has a high stock price. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain. Conversely, a company may have a low P/E because its stock has been slammed in anticipation of poor future earnings. Thus, what looks like a “cheap” stock may be cheap because most people have decided that it’s a bad investment. Such a temptingly low P/E related to a bad company is called a “value trap.”

Other popular measures include the dividend yield, price-to-book and, sometimes, price-to-sales. These are simple ratios that examine the stock price against the second figure, and these measures can also be easily found by studying stock tables.

Investors seeking better value seek out stocks paying higher yields than the overall market, but that’s just one consideration for an investor when deciding whether or not to purchase a stock.

Picking stocks is much like evaluating any business or company you might consider buying. After all, when you buy a stock, you’re essentially purchasing a stake in a business.


http://guides.wsj.com/personal-finance/investing/how-to-evaluate-a-stock/?mod=rss_WSJBlog/#mod=how_to_widget

Understanding The Intricacies Of Price–Earnings Ratio

By Ernest Lim

Readers may be surprised why I am writing an article on price-earnings (PE) ratio, as it is one of the oldest and widely known ratios around. They are often quoted by analysts, stock brokers and readers. Most people know how to calculate a PE ratio and they know that a low PE signifies that the stock is cheap and vice versa. However, is this really the case? Should one buy a low PE stock over an average PE stock? Or should we consider other factors? These are the intricacies, which I will explore in this article.

What is PE ratio?

PE ratio means how many times current year’s earnings¹ that investors are willing to pay for the company stock. For example, according to my estimates, China Gaoxian FY10F PE is only around 3.0x. This means that investors are only willing to pay about 3x Gaoxian’s current year earnings (i.e. FY10F earnings) for Gaoxian stock. In other words, it reflects the confidence that investors have in the stock. Is this a sure signal that Gaoxian is undervalued? I will discuss more on low PE stocks in the paragraphs below.

PE ratio – how to calculate?

For readers who are unaware on how to calculate PE ratios, I have listed two usual ways below to calculate them.

• Market price of the company (i.e. market capitalization) / net income of the company; or
• Price per share of the company / earnings per share of the company

Interpretation of PE ratio

The PE ratio is meaningless by itself. We have to examine it using the following two common techniques.

Comparison with industry

We can either compare the PE ratio against that of individual companies, or against an average PE of firms in similar industry. There are two general points to note. Firstly, if the company is trading at a lower PE than its peers, it is cheaper than its peers. Secondly, different industries have different PE ratios. This is because some industries either experience higher growth rates, or stable growth rates with lower risk, thus they are able to sport higher PE ratios.

Comparison with time

The company’s PE ratio is compared against a three, or five, or a ten year time period to determine whether it is priced cheaply against its historical valuations. We should be cognizant not to use a period which is too short (i.e. < 3 years) as it may not have captured the entire business cycle of the company. Furthermore, the PE ratio may be affected by extreme events. For example, the PE ratios of most companies slumped to single digit levels between 2008 and 2009.

However, if we were to compare the ratio against a fifteen year data, it may be too long. The industry dynamics or the company’s fundamentals may have evolved over time. In my opinion, I will use either a five or ten year time period.

Reasons for a low PE

Oftentimes, I hear readers express disbelief on stocks which have extremely low PE ratios. There may be several reasons why a stock has a low PE ratio. Below are some of the reasons.

Growth – an important component

A stock with low or zero expected growth in its future earnings per share is unlikely to be ascribed a high PE ratio. Thus, PE ratios should be complemented with another ratio called “Price earnings to growth ratio”

(PEG). This is calculated in the manner below:
PEG = PE / growth rate in annual earnings per share

Generally,
If PEG ratio < 1, company is undervalued.
If PEG ratio > 1, company is overvalued.

Therefore, besides looking at PE ratio, one has to take into account of the company’s growth rate to determine whether the company with the low PE is justified.

Incompetent or dishonest management

Firstly, I believe most readers would agree that the quality of the management is critical to the long term viability of the company. If management is incompetent, it is very difficult for the company to consistently generate an above average return on equity. It is more likely that over the long term, the incompetent management may have destroyed shareholder’s value. Thus, it is justified for the stock with poor management to have a low PE ratio.

Secondly, a company which has, or just had accounting irregularities before will command a lower PE ratio. This is because investors would have doubts on its financial figures (e.g. earnings), and consequently give a lower PE ratio to the stock.

Poor communication with shareholders

Usually, an outstanding company may have a low PE, simply because investors do not understand the company well. This is due to inadequate communication between the management and the shareholders. Some companies’ management may view that it is sufficient just by doing their business well and they are unlikely to spend additional time to engage with the shareholders and the investment community. Some management may believe that value speaks for itself. However, for listed firms, it is unlikely that pure devotion to work can deliver outstanding stock returns and high PE ratios for the firms. This is because if shareholders and the investment community do not understand the companies, it is difficult for them to feel confident on the companies’ earnings and prospects, and this will affect the PE ratios that the companies can command.

Temporary downturn in the company or industry

A company may have experienced one or two quarters which is poorer than analysts’ estimates and investors may punish the share price, sending its PE to a figure which is lower than its peers. For this company, it would be good to do some detailed fundamental analysis to ascertain whether this sub par performance is permanent or temporary. If the company has just hit some temporary obstacles, which resulted in posting poorer than expected results, then it may be good to start to accumulate the stock if investors believe that the company can turn around soon.

Separately, a great company may have a low PE in an industry which is facing lackluster growth rates. This is because investors (rightfully) believe that it is generally difficult for a company to post above average earnings growth rate in a poor industry. However, there is one exception to this. If the company, such as China Gaoxian, is sporting a low PE ratio in an industry, which is starting to rebound from the trough, it may be a good idea to accumulate in this company.

PE ratio – May be subject to manipulation

Readers should be aware that PE ratio is a function of price and earnings. Earnings are based on accounting principles and thus the choice of accounting principles would have an impact on the earnings. For example, given the same assets, net income for company A will change depending on whether he uses a straight line depreciation for its assets or a double declining balance method. Thus, the quality of the PE ratio is dependent on the quality of earnings.

Conclusion

Although the PE ratio is one of the most widely known ratios around, it is pertinent for readers to understand the intricacies in the application of the PE ratio. By doing so, the PE ratio will become another effective tool in the investors’ armoury in finding good investment opportunities.

1 It depends on the type of earnings used in calculating the PE ratio. It can be historical, or current, or future earnings. In my example, I have used China Gaoxian’s FY10F earnings per share, thus the earnings used is current year’s earnings.

Ernest Lim currently works as an assistant treasury and investment manager. Prior to this role, he was with Legacy Capital Group Pte Ltd, a boutique asset management and private equity firm, as an investment manager since 2006. He received a Bachelor of Accountancy (Honours) from Nanyang Technological University in 2005. He is a Chartered Financial Analyst, as well as, a Certified Public Accountant Singapore. He is currently taking a short break before embarking on a new role.

http://www.sharesinv.com/articles/2010/04/16/intricacies-of-pe-ratio/ 


Comment:  An excellent article on PE

Earnings Yield: Bond versus Growth Stock

PE Ratio and Growth

It would be nice if looking at price, P/E, and earnings yield was all there is to it. Find an earnings yield of 6% (PE of 17), beat the bond, and move on.

But you're buying equities, not bonds, right?

• Because you want to participate in company growth and success.

And why do you want to do that?

• Because, simply, you want to leave that static bond yield in the dust - if not today, sometime in the near future.
• And you want to keep up with - or better yet, beat - inflation.
• So to do that, you assume some risk that earnings won't happen, but you are hanging your hat on growth and a stock price that keeps up with it.

Given these choices, what would you do?

• Buy a bond for $100; receive $5 per year for 10, 20, 30 years; never look back.

or

• Buy a stock for $100, earnings per share constant at $5 for 10, 20, or 30 years with no change.

Should have bought the bond. Why?

Less risk.


----


But suppose the $5 earnings "coupon" grows at 10% per year. What happens at the end of year 10?

If the price were to stay the same, your $100 investment would be returning $12.97 in year 10, which is almost 13% earnings yield, or an implied PE of 7.7 at today's price.

A pretty nice yield, which really means the price of your investment should go up, because it's worth more.

This spreadsheet shows future earnings yields realized in the case of a bond with no growth versus a stock with a 10% earnings growth.

http://spreadsheets.google.com/ccc?key=0AuRRzs61sKqRcjdfd19OVTZrVVRlTUJnb05naGo3TWc&hl=en

So you can see that assessing growth is a major factor in analysing a stock price through PE.

Above all else, earnings growth drives stock price growth.

So value investors look closely at what the earnings yield is today and what will it be in the future.

PE Ratio and Future Stock Returns

PE Ratio and Future Stock Returns

Although the PE ratio can be a very misleading indicator of future stock returns in the SHORT RUN, in the LONG RUN, the PE ratio is a very useful predictor. The reasons may be understood by analysing how stock and bond returns are calculated.

Current yield of a bond
= interest received / the price paid

This is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.

Earnings yield of a stock
= EPS / Price
= 1 / (PE)


Bonds vs Stocks

Stocks

• Since the underlying assets of a firm or stock are real, the earnings yield is a REAL, or inflation-adjusted, return.
• Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.

Bonds

• In contrast, the NOMINAL return earned from fixed-income assets, where all the coupons and the final payment are fixed in money terms and do not rise with inflation.

The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns.

• The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%.
• This earnings yield exactly matches the 6.8% real return on equities from 1871.

Predicting Future Short-term Stock Returns using PE ratio

There are limitations to using the PE ratio to predict future short-term stock returns.

For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.

And in the short run, there are many other sources of market movement, such as:

• changes in interest rates or
• the risk premium demanded by stockholders.