September 07, 2006

HOW DO YOU DETERMINE THE INVESTMENT QUALITY OF AN ORDINARY SHARE?

"Record numbers are now playing the market."— Newsweek, July 5, 1999. This is not only true in the U.S., but in Trinidad and Tobago many individuals who once found the stock market a mystery are now buying up shares in companies, with the hope that the firm in which they are investing will prosper and their stocks appreciate in value. In fact, the truth be told, many of these investors know very little about the market or the stocks that they are buying or selling.

This then raises the question, how can an individual determine the investment quality of an ordinary share? The booklet, Facts about the Stock Exchange makes the following recommendations:

1. the ownership of an ordinary share confers a claim to the net income of the company, so shares are initially appraised on earnings and payout of earnings, i.e. dividends;
2. they are appraised on the future outlook for the company, since if the earnings and dividends are expected to increase and maintain that increase, the market will place a premium on the stock in the form of a higher price/earnings ratio and a lower current yield, usually reflecting a low pay out as earnings are ploughed back into the business for future expansion and growth. Ratios that a potential ordinary stock investor should therefore look at are:

• Earning Per Share (EPS) – i.e. net earnings after payment of preferred dividends divided by the number of outstanding common shares. Is it rising, stable or cyclical? The earnings per share record is one of the most important factors in appraising an ordinary stock.
• Price/Earnings Ratio – The price per share divided by the earnings per share. This figure should be related to the P/E ratios for other companies in the same industry and to the comparable current P/E ratios in general. A higher than normal P/E ratio could be an indication of an over valued stock or a general belief by investors that the earnings of the company will increase sharply over the near future.
• Payout and Dividend Yield: Payout to the percentage of earnings paid out to the ordinary shareholders as dividends. Yield refers to the dividend paid expressed as a percentage of the value of the investment. E.g. a dividend of $0.66 on a stock worth $6.90 represents a 9.57% yield ($0.66 / $6.90 x 100%).

However, Facts about the Stock Exchange notes that nowadays many buyers of ordinary shares are more interested in earnings growth and consequent appreciation of their capital than in yield via dividend income.