Feb 03, 2012
SVL to delist from TTSE
Gaming and lottery company Supreme Ventures Limited (SVL) has opted to delist from the Trinidad and Tobago Stock Exchange (TTSE), citing low trading volumes.
[ more . . . ]

Feb 02, 2012
Insurance executive joins NFM board
National Flour Mills (NFM) has appointed insurance executive Alimuddin Mohammed to its board of directors.
[ more . . . ]

Feb 02, 2012
SVL - Consideration of Dividend Payment
Supreme Ventures Limited has informed the Stock Exchange that a Board Meeting will be held on Friday, February 24, 2012 at 9:00 a.m. to consider the payment of an interim dividend.
[ more . . . ]

Feb 01, 2012
SIJL - Annual General Meeting
Scotia Investments Jamaica Limited has advised the Stock Exchange that the Annual General Meeting for the Company will be held at the Jamaica Pegasus Hotel on Friday, March 2, 2012 at 2:00 p.m.
[ more . . . ]

<< Opinions and Analysis

Evaluating Returns on Equity Investments

April 15, 2004

Last Thursday I dealt with the P/E ratio and offered an explanation as to what the ratio meant and how it should be used. As you would recall, the P/E is regarded as one of the simplest and most common of all financial ratios. The general rule is that the higher the P/E the higher the business is valued and the lower the P/E the lower the risk associated with that particular investment.

The P/E multiple is one aspect of the investment decision making process and allows for comparison between stocks in the same sector. Outside of stocks there are differing types of investments such as bonds, cash and real estate. Your percentage holding in any combination of these assets depends on your investment horizon and your attitude to risk. Yet regardless of the asset allocation in your portfolio, there needs to be some mechanism for determining the investment returns on your assets.

From the perspective of equity investments, returns are measured using two basic types of yields: dividend yield and earnings yield.

Dividend Yield

The dividend yield is measured by dividing the dividend paid on a share by the price of the share. For example, if a stock has an earnings-per-share of $1.50, pays a dividend of $0.50, and had a market price of $30 per share, the stock's dividend yield would be 1.67% ($0.50 divided by $30.00), and its price earnings ratio (P/E) would be 20 (the price of $30.00 divided by the earnings per share of $1.50).

Earnings Yield

The other ratio, the earnings yield is simply the inverse of the PE ratio. In other words it is the E/P (the EPS divided by the share price). So for the same example above, if you divide the P/E ratio into 1, you will obtain the stock's earnings yield. In this case, you would divide the P/E of 20 into 1 and the result would be 5%. (You could also calculate the earnings yield directly by dividing the earnings per share by the price of the share, or $1.50 divided by $30.00, which equals 5 %.)

Interpreting Yield

An analysis of these two yields offers important insights into the value of a share for investors and as a result should factor in your investment decision. The dividend yield provides an indication of the income generated by a share of stock. The earnings yield states very succinctly how much a business is able to return to you, the investor, in terms of net earnings for every dollar you must invest to buy the shares at the current market price. In our example the stock is trading at 20X and its earnings yield is 5%. This suggests that for every dollar invested, the investor has claim to 5 cents of current earnings.

While the simple definition of the earnings yield states that it is the inverse of the P/E ratio the calculation of the yield only makes sense when earnings are estimates for a future period, or realized earnings for periods in the past, and prices are recorded as at the beginning of the respective period. In addition the earnings yield assumes that all earnings are distributed (owned by shareholders). While this is often not the case it is still an important measure of company performance especially in light of the fact that companies often try to stabilize dividends or at least maintain a stable dividend payout ratio.

In earlier articles in this newspaper, I indicated that funds flows into the stock market when interest rates fall. If you use the earnings yield analysis you would have a better appreciation as to why. The accompanying table gives an idea of the earnings yield for shares on the market. This earnings yield is calculated based on the running EPS and the share price as at April 2003 and shows that over the past twelve months most companies have generated a yield of above 8% while some such as CCN have exceeded 13%. Now consider that debt instruments offered yields of between 4-7% over the same period. It should therefore be apparent that where the earnings yield on stocks is higher than that available on other investments it makes sense to invest in stocks.

The earnings yield can therefore be used as a tool to compare a stock to a non-equity investment, such as a bond after taking into account their relative risk. Even if fundamentals change and it is possible to obtain similar returns from both stocks and bonds one may still be tempted to stick with stocks even after considering the risks involved. An investor would do this because of his expectations for the company. Where a company is well managed and growing, its earnings may increase and therefore its value in the years ahead. If you expect the stock's earnings to increase over the coming years, and with it the price of the stock and the dividends, then a rational investor would be willing to buy it now and accept a lower return for that future growth.

Please send your comments to Ian Narine at iann@wisett.com

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