Price-earnings ratios, dividend yield and earnings guidance are three of the most common pieces of information investors use to decide which stocks they favour. But it’s important to understand the intricacies of these measures when making a decision to invest.
“On its own, P/E is meaningless. It’s only useful as a measure of value when comparing it to something such as the stock’s historical P/E, the P/E of other stocks in the sector or the P/E of the market as a whole," Briganti says.
But the danger of comparing a stock’s P/E to the market P/E is that if the stock’s P/E has always been higher than the market P/E, the stock could be properly priced, he says.
Comparing the P/E of one stock with that of another stock in the same sector tells an investor more about the investment potential of both stocks as they will have more in common than comparing one stock to the whole market.
“Comparing a stock’s P/E to its own history tells you if a stock is being treated differently," he says. “If the stock’s P/E is rising relative to its historical P/E, this could mean it’s becoming more expensive.
“But if the stock’s P/E is going up and the whole market is going up, then comparing historical P/E with current P/E won’t tell you very much.
“So you really need to know the intricacies of why a stock is valued the way it is to get the most value out of this measure.
“P/E also won’t tell you if the earnings of a company are coming from borrowings or from equity. It’s a simple measure because investors can easily get this data and it’s simple to understand.
“But it’s important to remember it’s always dangerous to read metrics in isolation."
“Yield is important in an environment when the cash rate and deposit rates are falling because people want income. High-yield stocks such as the Commonwealth Bank and Telstra have operated as a quasi bond because people have sought out yield."
Weston says investors generally look for stocks with a yield of 5 per cent or more, “but it’s important to remember as the price of a stock goes up, dividend yield drops". This is because dividend yield is a measure of the value of the dividend divided by the stock’s market capitalisation. If the market capitalisation goes up and the dividend stays the same, the yield will fall.
“Telstra is paying a cash dividend of 6.1 per cent, which rises to 8.6 per cent when you take into account franking credits," McCarthy says. “With a cash rate of 3 per cent, this is a real incentive to hold on to the stock."
He explains the stock would still produce an after-tax dividend yield of 6.6 per cent should the share price rise from its current level of around $4.60 to around $6 and the dividend remain unchanged. Only if interest rates were to rise to, say, 5 per cent, would investors reconsider holding on to the stock and instead take profits.
Another important indicator for investors is company announcements about revisions to earnings guidance. Share prices routinely rise when a company announces earnings are likely to be better than expected (the reverse is also true).
A recent example is industrial products manufacturer Bradken, shares in which rose from $6.10 to $7.63 – a jump of more than 25 per cent – on the back of better than expected future earnings growth potential.
“That’s the sort of reaction markets have with a better-than-expected earnings outlook," says McCarthy.
Briganti also suggests investors watch analysts’ recommendations.
“If the majority of analysts are downgrading a stock, that tells you there’s sentiment against it. If analysts are increasing their earnings’ estimates for a stock, that’s a positive signal," he says.
“But although earnings revisions may be positive, the stock may still have low earnings growth potential. Reading one metric in isolation is a recipe for disaster. The idea is to look at as much data as possible to get a picture of the overall health of a company."
The Australian Financial Review