The Market Value of Shares: Analysis, P/E Ratio and Dividend Yields

When assessing the value of a share, an investor will need to conduct some analysis. Share traders and investors want to buy shares at a low price and sell at a high price.

However, just because one share is trading at a lower price than another does not mean it is better value. When assessing relative value it is necessary to compare profitability, revenues, cash in the bank… in fact a number of factors before making an informed decision.

There are two types of analysis that are used when assessing investment value of shares.

1. Technical analysis

technical analysis

Technical analysis has its basis set in the history of price and price change momentum.

While some ratios are produced in helping to predict future price change, the majority of technical analysis relies on the production of charts and the identification of repeating patterns of price movement. This type of analysis is used mostly by short to medium term traders, with some often changing trade direction after just a few minutes of buying or selling stock.

2. Fundamental Analysis

fundamental analysis

Contrary to technical analysis, fundamental analysis has its feet firmly in the evaluation of a company’s health when measured against its financial metrics. Key financial information, such as earnings, revenue, sales, and cash and debt, are assessed and measured against the company’s own history and the financial measures of likeminded companies.

While stock market analysts working for the largest investment houses may have direct access to company directors and finance officers, all publically traded companies are obliged to reveal price sensitive information to the whole market at the same time. This means that, in essence, any investor knows just as much as the next.

Two of the most common valuation ratios used by investors are the price to earnings ratio and the dividend yield.

Price to Earnings Ratio (P/E)

picture_price_earnings_ratio

On the face of it, a company that is making a profit of £100 million is more profitable than one making just £50 million. However, this is only part of the story, for if that first company has 100 million shares in issue, and the second has only 25 million shares in issue then the profit per share of each company could be said to be £1 per share and £2 per share respectively.

Now it looks as though the second company is the more profitable, for every share an investor owns is producing twice as much profit as those held by the investor in the first company.

The real value of the shares using earnings alone, however, can only be properly assessed by factoring in the share price as a component of value.

In the above example, consider that the share price of the company making £1 per share profit is £10. For every £10 share, earnings of £1 are produced by the company. That is a price to earnings ratio of 10.

Now consider that the second company, which is producing earnings of £2 per share, has a share price of £40. Its P/E is 20 (40/2).

In other words, were an investor to buy shares in the second company he would be paying twice as much as an investor in the first company to amass the same earnings. If all things held equal, and every single penny of earnings produced by both companies were paid to shareholders as dividends, it would take 10 years for the investor in the first company to recoup his investment, and twenty years for the investor in the second company.

The P/E ratio gives a relative valuation of a company’s financial health when measured against its own previous history and the current market.

Dividend Yield

Many investors buy shares for the income potential of their dividends.

The dividend yield is a way of quantifying the income paid by a company to its shareholders and allowing easy comparison to other income yielding investments and shares.

To calculate the dividend yield, it is necessary to divide the dividend by the share price.

For example, a company whose shares are trading at £5, and is paying an annual dividend of 25p will be paying a dividend yield of 5%. This figure can then be compare to other likeminded companies, or, indeed, to the interest payments the investor would receive were he to deposit his cash into an interest bearing bank account.

In Summary

Investing wisely is about spotting value in shares. It is often said that price is what an investor pays, but value is what is bought. Just because a share is trading at £5 does not mean it is more expensive than a share trading at £1. The value of shares is dependent upon many factors, and share price is only one component of the assessment if value.

When analysing companies and their shares, it is always necessary to compare like with like. Different business sectors move in different directions, and the relative valuation of one type of company will be different to another. Never compare apples with oranges, but only to other apples.

It is also wise to acquaint oneself with several valuation ratios and learn how to use them properly. While two of the most common have been discussed here, there are many more. The more analysis of numbers conducted, the more accurate the assessment of value will be.

Finally, when conducting share analysis and selecting the best shares to buy care must be taken that the data input to produce relative valuation ratios is correct. A misplaced decimal point or an incorrect earnings number will skew the final calculation and a bad investment could be the result.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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