Whether in res­pect of inter­national equi­ties or local equities, one still comes across individuals who look at the absolute price of a share to determine if it is high or low rather than looking at the important indicators which reveal the fundamental strength of the company.

Not long ago, I had written an article on some indicators one should look out for when investing in bonds. In this case, two important ratios are the interest cover and the gearing ratio which shows the extent of leverage of the borrower. While bondholders’ main concern is whether the company can honour its yearly interest payments and its obligation to repay the bond on maturity, the focus for equity investors is very different.

Investors acquiring shares in a company do so primarily for capital growth prospects that may exist going forward coupled with the receipt of a regular dividend. Therefore, investors need to determine whether the share price of a particular company is overvalued or undervalued and whether the dividend is attractive in the circumstances and sustainable going forward.

The most widely used indicator to determine whether a share is cheap or expensive is the price to earnings ratio or p/e ratio. This ratio indicates the relationship between the share price of a company and the earnings generated by the company per share. The higher the ratio the more expensive a company’s equity is. However, companies operating in different economic sectors may not be comparable due to the varying characteristics within each industry.

For example, the p/e ratio of companies operating in the banking industry cannot be compared to those of the telecoms sector. Companies within the telecoms sector account for a much higher level of depreciation on their equipment on a yearly basis and this reduces the profitability of such a company, thereby producing a lower level of earnings and pushing up the p/e ratio. Furthermore, depreciation is a non-cash item and simply an accounting movement in a company’s financial statements. In this case, the EBITDA (earnings before interest, tax, depreciation and amortisation) multiple may be a more useful metric. The same can be said for an airport operator such as Malta International Airport plc.

The dividend yield reflects a company’s percentage return to shareholders by way of cash dividends based on the current share price. The dividend yield is an important indicator for shareholders since it provides them with an indication of the percentage return they earn on the present value of their equity holding. It also enables financial analysts to compare dividend yields (cash returns) across sectors.

Naturally, a high dividend yield is the most desirable for investors especially when interest rates on other investments are at very low levels. However, although a high yield may be attractive at first glance, it is important to check whether this has occurred as a result of a steep decline in the share price, in which case investors have to exercise caution since such a development could indicate problems with the future profitability of the company.

It is equally important to look into and ascertain whether the company can sustain those dividends or better still grow dividends to shareholders going forward.

These companies are normally referred to as “dependable” companies and it is also recognised that such companies deserve to trade at a premium to the market.

The recent share price performance of Go plc is a good example of investors’ perception on the sustainability of a dividend. Although Go distributed a lower dividend for 2009 (a net dividend of €0.10 per share compared to a dividend of €0.12 per share for the previous year), the decision to declare a dividend despite incurring a loss of €6.7 million results from the high level of cash flow generated by Go from its activities.

The announcement by Go to declare a dividend of €0.10 per share should have given the market a strong indication that the group is willing to maintain strong returns to shareholders and this should have provided support to the share price.

However, notwithstanding this dividend announcement in March 2010 and the improved performance from their local operations during the first half of 2010 indicating an increased probability of the company maintaining its yearly dividend, the share price drifted lower in recent months. At the current share price of €1.895, the historic gross dividend yield is of 8.13 per cent per annum. The market seems to indicate that it is uncertain whether Go could maintain this dividend going forward. However, Go’s declining share price could be due to concerns on the future of the group’s €110 million investment in the Greek telecoms company Forthnet, and not because the market doubts the sustainability of the dividend.

The share price performance and trading activity at RS2 Software plc and Grand Harbour Marina plc could also be due to the uncertainty over future dividend streams. Although both these companies rank above HSBC Bank Malta plc in terms of historic dividend yield, investors are shunning these equities as evidenced by the very low trading activity in both companies.

Possibly the best use of the p/e ratio and dividend yield in the local context is through a comparison of Bank of Valletta plc and HSBC Bank Malta plc, two of the largest and most actively traded equities operating within the same sector.

The September 2010 financial results recently published by BoV give an earnings per share figure for the bank of €0.3172 and compared to a share price of €3.70, the p/e ratio is of 11.7 times. On the other hand the p/e ratio of HSBC is 18.5 times although this is based on last year’s results. Last week, HSBC issued its Interim Directors’ Statement claiming that the positive trend in revenue and profitability reported in the first half of this year (when the Bank registered a 21 per cent increase in pre-tax profits to €42.2 million) continued during the subsequent months.

Hence this should translate into a higher earnings per share and a lower p/e ratio for HSBC once the 2010 financials are published, although it would seem unlikely to fall as low as that of BoV. With respect to the dividend yield, BoV’s yield of 6.4 per cent per annum is higher than that of HSBC at 5.4 per cent per annum. In this respect, however despite the likelihood of increased profitability for HSBC in 2010 over 2009, the dividend is unlikely to rise in line with the improved profits since, in August, HSBC announced that it was reducing its dividend payout ratio to 55 per cent in view of more stringent capital requirements going forward.

Although these two indicators suggest that BoV’s equity is cheaper than HSBC’s, some investors continue to view HSBC as a cheaper share since the absolute share price of HSBC at €2.91 is lower than that of BoV at €3.70. As evidenced by the p/e ratio and the dividend yield, this is not the case.

Another important metric is the book value per share and the relationship of the share price to the book value.

Generally companies trade at a premium to the book value, however, property companies almost always trade at a discount to book value.

Understanding and correctly interpreting certain indicators is important for investors as this should help them to benefit from pricing anomalies in equity markets and to ensure a proper allocation in their portfolios to those companies that offer good capital growth prospects and render an attractive and sustainable dividend going forward.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd, “RFC”, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the issuer/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

© 2010 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

www.rizzofarrugia.com

Mr Rizzo is director of Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

Sign up to our free newsletters

Get the best updates straight to your inbox:
Please select at least one mailing list.

You can unsubscribe at any time by clicking the link in the footer of our emails. We use Mailchimp as our marketing platform. By subscribing, you acknowledge that your information will be transferred to Mailchimp for processing.