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Sunday, 13 January 2013 08:19

Australian Share Market - How can you tell if it's cheap?

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There are many ways of measuring value in the share market, but today we will concentrate on two.

1. Price Earnings Ratio

The Price Earnings ratio (PE) measures the share price divided by the earnings of a company.  If Company A had a share price of $1-00 and had earnings per share of $0-10, then the PE multiple would be 10.  If the share price however doubled to $2-00 while the earnings remained the same, then the PE multiple would be 20.

There is no hard and fast rule about PE ratios, but clearly the higher the PE ratio, the more expensive the company.  Of course a company that is growing its earnings quickly may look expensive today but as earnings grow the PE multiple reduces assuming the share price remains unchanged.  For example Company A with a share price of $1-00 and earnings of $0-10 per share, doubles its earnings to $0-20 per share now has a PE multiple of 5.

Below is  a chart showing the forecast PE multiples for the Australian share market as at today and compares the ratio historically.

Forward PE ratios

You can see that the forecast PE ratios are at the low end of where they have been since the 1980's, which implies that based on this measure, the Australian share market is not expensive.

2. Dividend Yield

The dividend yield is simply a percentage of income that is paid to investors from a share in a company.  It is calculated by dividing the dividend paid by the share price x 100.  For example Telstra pays a 28 cent dividend and assuming a share price of $4.50 represents a dividend yield of 6.22% (0.28/4.50 X 100).  When the Telstra share price was around $3 it was still paying a dividend of 28 cents per share, which equated to a dividend yield of 9.33%.  This does not include the benefit of imputation which is discussed elsewhere.  A simple way of looking initially at dividend yield is that the higher the yield the better the value.

Investors need to determine whether a dividend is sustainable by looking at what percentage of company profits is paid out as a dividend as well as the sustainability of profit levels.  For example a company that pays out 90% of its profits as a dividend may not be able to sustain its dividend, particularly if profit falls, versus a company paying out 70% of its profits as a dividend.

Dividend alone is not a determinant of value as many companies reinvest heavily back into their business rather than pay higher dividends to investors.  That said when considered across an entire market, dividend yield provides some clue as to whether a market is cheap or expensive (ie a higher dividend yield implies the share price is cheaper, while a lower dividend yield across a market implies share prices are more expensive)

Here is a chart showing the dividend yield of the Australian share market as well as its history.

Dividend Yields

Australian dividend yields are materially higher than their global counterparts (measured as MSCI World in red).  You would also notice that Australian dividend yields are relatively high compared to where they have been over the past 25 years, which implies that the Australian share market is relatively inexpensive.

We caution investors in attempting to value shares using only one method as there are many other aspects that should be considered.  However on two of the more commonly used valuation methods, the Australian share market appears attractively priced for investors.

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

Read 2377 times Last modified on Friday, 08 February 2013 15:00
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