Investing with the JSE Price to Earnings Ratio Method 3 of 3

30 June 2016 | Charles Collocott, CFA
 


Also Read: Part 1 | Part 2

Introduction

This is the third of 3 methods I’m taking you through that show how to use the daily JSE trailing Price/Earnings ratio to manage risk in your investing and/or trading decisions. The P/E ratio is a valuation ratio of a company’s current share price compared to its per-share earnings, calculated as:

Market Value per Share / Earnings per Share (EPS)

For example, if a company is currently trading at R43 a share and earnings over the last 12 months were R1.95 per share, the P/E ratio for the stock would be 22.05 (R43/R1.95). The JSE’s P/E ratio is merely the same calculation, but conducted on the sum of all its constituents (over 350 shares). It thus gives the aggregate P/E ratio of the whole South African stock market. However, the JSE market capitalisation is dominated by the top 40 large-cap shares (it is very ’top heavy’) and so in reality these 40 shares’ earnings will likely dominate the overall JSE’s P/E ratio.

When a P/E ratio is low, the shares’ (or market in the JSE’s case) are considered to be cheap. When the P/E is high, it is considered expensive. Clearly buying the JSE (through a SATRIX-40 or other ETF) when it is cheap is less risky than buying the JSE when it is expensive. We present a number of tools using the JSE overall P/E (of the whole market) to gauge your market risk.

Method 3: Relative Valuation

Rather than examine the JSE’s P/E ratio in isolation, this method compares it to competing returns from cash, after adjusting for inflation. The model compares the valuation of equities by measuring JSE ALSH Index’s’ Earnings Yield (inverse of P/E) less Inflation, to interest you can earn in cash (a competing asset class) through the ratio:

R = (EY-CPI)/CASH RATE

Ratios above 0 imply equities are favourable over cash and other fixed interest assets, and ratios below zero imply fixed interest assets are favourable over equities. The idea is that as P/E ratios fall (thus raising Earnings Yields), either through strong earnings growth or a correction, and inflation drops, then equities become favourable over cash. As interest rates and/or P/E ratios rise and inflation rises, then cash becomes favourable to equities.

The ratio is shown in red below, together with green shaded areas where a timing model would have us in equities (when ratio is >0) or white areas when we are in cash earning prime less 4 (when ratio < 0):

image1

The ratio also indicates the relative attractiveness of either asset class - when it is high equities should be overweight and when it is very low, cash should be overweight. The timing model has two powerful growth impacts- firstly, it keeps you out of the majority of the bear markets, and secondly, it leverages high interest rates when in cash. Its performance over the last 15 years (12 trades) is shown below as at February 2012:

image2

The timing model (for PowersStocks clients) is updated daily in the MACRO charts group as shown below. The light grey line is the actual Cash/Equity ratio calculation for the day R=(EY-CPI)/CASH RATE, the black line is the exponential moving average of R that is used to signal buy and sell alerts, red vertical lines are sell signals and green vertical lines (not shown) are buy signals:

image3Note: All graphs produced using PowerStocks software. For more information on PowerStocks click here.

Also Read: Part 1 | Part 2


Charles Collocott, CFA

CFDs & Securities Manager, Sharenet

You will be hard pressed to find someone more qualified than Charles to assist you with seamlessly interacting with the markets through Sharenet’s Securities and CFDs trading platforms. Charles began his career in 2006 as a trader at Peregrine Equities, South Africa’s leading prime broker and has also been a trader at Legae Securities as well as a buy side trader and part time market and stock analyst at Cannon Asset Managers. In addition to being a CFA charter holder, Charles also has an undergraduate degree in Politics, Philosophy and Economics from the University of Cape Town.

http://www.sharenet.co.za/v3/trade/


Disclaimer:
The information contained in this article is for informational purposes only and must not be regarded as a prospectus for any security, financial product or transaction. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial issue. Investors should consider this research/article as only a single factor in making their investment decision. We recommend you consult a financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs. The views and opinions (where expressed) in this article are those of the author and do not necessarily reflect the official policy or position of Sharenet.

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