The Growth Factors

Sydney Morning Herald

Wednesday October 31, 2007

By Barbara Drury

There are some basic measures that can help you select stocks that perform over time.

After four years of exceptionally strong growth, Australian shares are starting to look fully priced - if not expensive. This is no cause for panic but it is a good time to flick the switch to value for money. The problem for investors who want to base their decisions on more than gossip, gut instinct or a soaring share price is how to work out whether the shares they buy are worth the money they pay for them.

A booming market lifts the share prices of mediocre and good companies alike but only the best will withstand the test of time.

Andrew Pease, a strategist with the Russell Investment Group, argues Australian shares are now overvalued compared with overseas markets. In his October market report, Pease says the local market is trading on a forward price-to-earnings (P/E) ratio of 16, the highest since 2002 and a 10 per cent premium on global markets. Historically, Australia trades at a 10-15 per cent discount to its global peers.

Not everyone can crunch the numbers the way Warren Buffett does but there are some simple and readily available measures that everyone can use to gauge value for money.

PRICE-TO-EARNINGS RATIO

The price-to-earnings ratio is used to gain a quick understanding of the performance of a share. Forward P/Es are based on estimates of this year's earnings, while historic P/Es are based on last year's earnings.

Educator and author Colin Nicholson says "there's been a fair bit of research showing it's quite a good marker for value".

The P/E ratio is calculated by dividing the share price by earnings per share, which in turn is the company's after-tax profit divided by the number of ordinary shares on issue.

Woolworths is trading at about $31.30 a share. If you divide this by earnings per share of $1.08 you end up with a ratio of 28.8. P/Es are listed in this paper's daily share price tables and on many free online sites.

The P/E tells you roughly how long it will take to earn back the money you have invested in each share. In the case of Woolworths, it will take almost 29 years of earning a return of $1.08 a share to recoup an investment of $31.30. Woolworths high ratio indicates investors are extremely optimistic that it will increase its earnings. In other words, the P/E ratio tells us as much about market sentiment as it does about the company's performance.

A very low P/E ratio could mean the shares are undervalued or that the company is a real dog with little chance of any growth.

In practice, unless you have a high degree of confidence in a company, Nicholson says it is best to avoid shares with extremely high or extremely low P/Es. It is also a good idea to keep in mind the overall market P/E and the P/E of companies operating in the same sector to see if there is better value elsewhere.

The Australian market is currently trading on an average P/E of 14.8, which is close to the historical average. The consumer staples sector, of which Woolworths is part, currently trades on a P/E of 22.33.

DIVIDEND YIELD

Dividend yield gives an indication of the investor's annual return for holding the share. Investors who depend on their shares for regular income target companies with relatively high-dividend yields.

The dividend yield is simply total dividends paid for the previous 12 months divided by the number of shares, with the answer divided by the current market price.

Say a company has a dividend yield of 5 per cent. That means that for every $1000 invested you could expect a return of $50 a year.

The average dividend yield for Australian shares is 3.44 per cent. Listed property trusts are favourites among investors dependent on income and currently have an average dividend yield of 5.44 per cent.

A consulting actuary and author, Nick Renton, pays less attention to dividend yield than price to earnings ratios. If directors decide to retain a greater proportion of their earnings in order to grow the business, rather than distribute profits in the form of dividends, he argues shareholders ultimately benefit from higher company earnings and a higher share price.

Conversely, Nicholson says, some companies have a policy of paying out most of their earnings as dividends because they don't need the capital to grow their earnings. For example, GWA and Hills Industries have a 100 per cent payout ratio and respective dividend yields of 4.6 and 4.8 per cent.

Remember it is the total return in your hand at the end of the year that is important, so dividend yield and capital growth must both be taken into account.

RETURN ON EQUITY

Return on equity measures the profits a company makes on its ordinary share capital. Roger Montgomery of Clime Asset Management argues the return is the most important measure of whether a company is wonderful or mediocre. "Only companies with high rates of return on equity can turn $1 of retained profits into more than $1 of long-term market value," he says.

The return on equity is a little more difficult to track down but can be found on many online investment sites. Divide net profit by shareholders' equity and multiply by 100 so it's expressed as a percentage (shareholders' equity refers to ordinary share capital plus reserves and retained earnings or accumulated losses). The higher the return, the more profitable the company.

Montgomery looks for companies with a return of 20 per cent or more. However, he says a sustainable return, with little or no debt, is more important than the actual percentage figure and suggests a company with a competitive advantage.

Montgomery says companies can have a high P/E or dividend yield but a low return on equity, indicating they are not the most profitable investments. For example, One.Tel had a high P/E but that didn't stop it going under. He cites UNiTAB, which was taken over by Tattersall's last year, as an example of a company that had the best of both worlds. It paid out all its earnings as dividends while the return increased every year. "It didn't put any money back into its business and profits went up."

© 2007 Sydney Morning Herald

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