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By Bruce Jackson (TMFGoogly)
Baker Street, London -- Following on from my valuation thoughts of last week, today I thought I'd look at something called the earnings yield. I'm applying this to individual companies, not the market as a whole. It is calculated quite simply as:
Earnings Per Share ------------------- Share Price
If you paid 100p for a share and it has annual earnings of 10p per share, your annual rate on return would be 10% (10p / 100p = 10%). Note that the variable is the share price, as it changes on a daily basis. So, if the share price fell to 50p, your earnings yield would rise to a very attractive 20%. Likewise, a rising share price has the opposite effect. All this goes to show that the price you pay for a share of a company very much determines your rate of return. It's yet another way of saying that in the long-run, valuation ultimately matters.
Of course, the effectiveness of this type of thinking depends entirely on the predictability of a company's earnings. On an unchanged share price, a year one 10% earnings yield can very quickly turn into a year two yield of 5% or even 0%, given the worst case scenario. That's why one of the Qualiport's tenets is "A company which you understand, and which has predictable earnings."
Thinking about the earnings yield when assessing a company's value instantly enables you to compare an investment in one form of asset to another. Base interest rates are currently 5.25%, although they are expected to rise in the not too distant future. The risk-free government 10-year bond yield is 5.75%, and the risk-free 30-year bond yield is 4.75%. By comparison, our company with its 10% earnings yield looks an attractive proposition.
Of course, any investment in shares is not risk-free. Even over the very long term there's a chance that you'll lose money on any given individual or portfolio of shares. Even Marks & Spencer (LSE: MKS), that venerable High Street name, has not been immune. The last time its shares were below 300p was way back in 1992. That's seven long and lost years for long-term shareholders.
One thing the Qualiport has got right this year was selling our M&S holding, getting out at 392p. It's going to be one hell of a bumpy ride back for Big Green. The dividend yield should place some firmer footing under the share price; at 300p it stands at 4.8%. Of course, if things continued to go horribly wrong, there's always a chance of M&S cutting its dividend. Personally I can't see that happening, but with dividend cover down to almost one, there's not a huge amount of leeway.
If shares are not risk-free and governments bonds are risk-free, then surely the investor should be compensated appropriately if he chooses to take on the risk of investing in equities. The gap between the respective share and bond returns is commonly known as the equity risk premium. Since 1918, equities have returned an average of 12.2% per annum. In that same period, gilts (or government bonds) returned 6.3% per annum. The difference, 5.9%, can be used as the long-term proxy for the equity risk premium.
However, given we're Foolish long-term holders of equities, I'm struggling to come to terms with why there should be a risk premium attached to owning shares. As we've seen above, they have outperformed all other forms of investment, over the very long-term. Surely therefore we should be willing to pay even more for equities than we already do, given the FTSE 100 is trading at an historically high trailing price to earnings ratio (P/E) of 27? This is something academics all over the world have been pondering, including coming up with all sorts of complicated equations and formulas which either prove or disprove the theory. I'll leave that to them. The over-riding thing to remember is that over the long-term, stocks outperform all other forms of investment -- period!
Coming back to the earnings yield, after the market falls of last week and today, it's interesting to look at a couple of existing Qualiport companies which are starting to look quite attractive top-up propositions.
Share Forecast Earnings
Price EPS Yield
Emap 797p 52.6p 6.6%
Independent Ins. 235p 17.0p 7.2%
The earnings per share (EPS) forecast for Independent Insurance (LSE: IIG) is my own quite rough back of the envelope calculation, based on a net profit after tax estimate of £40m (1998 figure -- £67m). All analyst EPS estimates are based on trading profit, which includes underwriting profit and investment income, but excludes gains or losses on realised and unrealised investments. When looking at IIG, and any insurance company for that matter, I always take the investment element into account, because I'm buying the whole company, not just the insurance portion of it. By the way, for IIG's net profit forecast, I assumed a £10m loss on investments. With weak bond and equity prices throughout 1999, a loss looks a certainty.
To give you a comparison, here's the earnings yield on two Qualiport companies which I'm not planning to top up on. That's because they've both got anaemic levels of sales growth.
Share Forecast Earnings
Price EPS Yield
Unilever 530p 25.7p 4.8%
Rentokil Initial 207p 13.4p 6.5%
Of the above four companies, the one I'm most attracted to is Independent Insurance.
Finally, here's the great thing about a company's earnings yield. It grows! If you bought a 30-year bond now, your yield of 4.75% is fixed at that level. It is effectively capped. But, as the years go by, a company which is growing its profits also obviously sees its earnings yield grow. If IIG could grow earnings by 12% per annum for the next 5 years, its 2004 EPS would be 30p. At today's price of 235p, that's an earnings yield of 12.8%! Compare that to your bond yield of 4.75%!
Of course this theory only works if you're looking at a company with predictable earnings. I believe IIG to be that type of company. Sure, there will be unexpected claims and losses over the years, but that's part of the insurance business. Happy with all that, and IIG's management and track record, in accordance with the Fool's trading rules, within the next five trading days the Qualiport will buy an additional £1000 worth of shares in Independent Insurance. Here's a link to the initial buy report, which is still very valid today.
Comments and thoughts encouraged to the Qualiport or IIG message boards. See you Wednesday.
Company Change Bid DELL(US)-1.50 42.70 EMA -0.16 7.92 IIG -0.10 2.33 MSY -0.11 5.07 PIZ -0.02 8.20 RTO 0.00 2.05 ULVR +0.04 5.28 LLOY +0.01 7.28 Qualiport Stocks Last Rec'd Total # Company Buy Current Change 04/11/98 245 Pizza Exp 7.93 8.20 3.5% 27/01/99 74 Dell (US) 44.63 42.70 (4.3%) 29/09/99 356 Lloyds TSB 7.56 7.28 (3.6%) 27/10/98 755 Indep Ins 2.58 2.33 (9.7%) 22/04/99 348 Misys 5.76 5.07 (12.0%) 19/12/97 783 Rentokil 2.55 2.05 (19.6%) 17/07/98 266 Unilever 7.53 5.28 (29.8%) 17/04/98 169 EMAP 11.34 7.92 (30.2%) Last Rec'd Total # Company In At Value Change 04/11/98 245 Pizza Exp 1966.34 2009.00 42.66 27/01/99 74 Dell (US) 2007.42 1915.03 (92.39) 29/09/99 356 Lloyds TSB 2723.20 2591.68 (131.52) 27/10/98 755 Indep Ins 1972.64 1759.15 (213.49) 22/04/99 348 Misys 2028.71 1764.36 (264.35) 19/12/97 783 Rentokil 2046.53 1605.15 (441.38) 17/07/98 266 Unilever 2052.00 1404.48 (647.52) 17/04/98 169 EMAP 2341.32 1599.84 (741.48) Cash: £2,710.26 Current Total : £17,358.95 Total Invested: £20,184.62 Profit/(Loss) : (£ 2,825.67) Value Per Share Day Month Year Qualiport -1.16% -4.93% -17.81% FTSE 100 -0.64% -2.66% -0.23% FTSE All Share -0.77% -2.73% 2.81%