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P/e lessons

Dividend yields are not the only value that an investor might hope for in holding equities as the vast majority of companies earn profits significantly higher than that required to maintain or even increase their dividend payments

In my last article, I discussed an updated overview of the different asset classes in the investment market, in particular regarding the impact on pension planning of expected investment returns in the foreseeable future.

In particular, I looked at cash, fixed interest and com-mercial property investing.

I have, in seminars and articles over the past few years, submitted my view that equities are undervalued by a number of technical calculations and benchmarks and I remain firmly of this opinion, as I will now detail.

Here , I will particularly focus my attentions on three main indicators of the real value of equities in the current investment climate – dividend yield, the price/ earnings ratio and current and expected corporate profitability.

As regards dividend yield, it is informative to note data in the FTSE Actuaries Share Indices (displayed on the same page as individual equity prices and by no means of interest only to actuaries, in spite of the title).

Among other useful information, these indices show that the average dividend yield on the All-Share index (summarising all the shares on the UK stockmarket, in contrast to the more frequently quoted FTSE 100 which relates to the shares in the biggest quoted companies) is, at time of writing, 3.1 per cent.

Currently, and perhaps importantly for investors selecting preferred equity funds, the dividend yield on the FTSE 100 is running slightly higher – at 3.3 per cent – while that from smaller companies, as represented by the FTSE Small Cap index, is running at only 1.9 per cent.

If the dividend yields were the only potential value to be derived from investments in equities, this asset class would obviously represent poor value when compared with expected returns from cash (4.5 per cent), Government bonds (4.5 per cent for medium-dated gilts), corporate bonds (5 per cent to 5.5 per cent for low-investment-grade issues) and commercial property (7.5 per cent to 8 per cent, as I discussed in my last article).

But the potential for capital growth in share prices, particularly over the medium to long term, should also be factored in to the outlook for total expected returns.

Before quantifying and discussing this outlook, I would like to remain on the subject of dividend growth a little longer to consider the likelihood or otherwise of dividend payments remaining at their current level, or increasing or decreasing in future years.

Over the last 40 years, dividends have risen in all but five years and even in these the decrease has been marginal, ranging from a fall of only 0.2 per cent to a fall of 4.4 per cent, in contrast to dividend increases in the other years as high as 20 per cent a year.

History, therefore, is on the side of continued growth although, of course, we must remain aware that “past performance is not necessarily” and all that.

If history might be expected to be repeated, though, and dividends continue to increase then one of two things must happen, remembering the current level of dividend yield of 3.1 per cent on the FTSE 100 index.

If share prices remain broadly the same, then the dividend yield will increase, making equity investment more attractive unless the yield or returns from the other asset classes also improve. Alternatively, and I would suggest more likely, as the increasing dividend yield makes equity investing more attractive, one might expect the forces of supply and demand to encourage increasing share prices.

How might we start to forecast future annual movements in dividend yields? Easy. Every Saturday in the Financial Times, a list of all company results – interim and final year – is published, listing for each company declaring their profits over the previous week the profitability (compared with that in their previous accounting year) and dividend declaration (again, compared with the previous period).

It only takes a few seconds to summarise how many companies have increased or decreased profitability (see further comments on this subject below) or dividend payments, or both.

I can save advisers a certain amount of speculative time by noting that, for a good number of years, a very significant majority of companies have increased both profitability and dividend payments in every week over which I have been conducting this little (but important) exercise.

I would therefore suggest that this quick summary – taking only a few seconds of an adviser’s time just once a week – could and should prove to be a very simple but effective early-warning system for identifying any reversal of fortunes in advantageous dividend and profitability trends.

But I would now like to expand on one of my earlier (and very obvious) statements a little earlier in this article – dividend yields are not the only value that an investor might hope for in holding equities as the vast majority of companies earn profits significantly higher than that required to maintain or even increase their dividend payments.

Profits in excess of the dividend payments are thereby retained and reinvested in the future of the business, giving obvious potential for the value of the business to increase and, one might expect, having a favourable impact on its share price.

Here, and very importantly, I would suggest, the price/earnings ratio is an extremely useful index. Currently, the average p/e ratio on the FTSE 100 index is almost exactly 12 (a little under 13 for the FTSE All Share index and about 25 for the FTSE Small Caps index – significant and important differences which I will explain further in my next article).

In simple terms, a p/e ratio of 12 indicates that if all of a company’s annual profits (taken from the profits in the last declared profits) were to be paid out in dividends then an investor buying shares in the company at their current level would recoup his outlay after 12 years’ of dividends.

This also, perhaps assisting a simpler understanding of the true implications of this p/e ratio implies that the potential dividend yield (that is, if all the profits were to be paid out as dividends) from the FTSE All Share companies is currently running at a little over 8 per cent (that is, 100 per cent divided by the p/e ratio of 12).

As we know these companies are paying an average dividend yield of around 3 per cent, then, albeit subject to adjustment for tax, we can ascertain that around 5 per cent a year is being retained within the business.

It could be convincingly argued, therefore, that total projected returns from equities could be estimated at 8 per cent but I would suggest that this should, in fact, be significantly higher.

Again turning to the afore-mentioned table in Saturday’s FT, from a quick summary of the annual profits for each week’s declarations it can quickly, simply, and usefully be noted that profitability is increasing significantly faster than could be explained by the simple retention of profits from previous years.

This, I would further suggest, indicates a healthy state of corporate affairs. Quite apart from subjective news or speculation about the future financial well-being of stockmarket-listed companies, these quick summaries derived from a convenient weekly source identify objectively current trends in corporate profitability and dividend payments.

In closing this article, certain aspects of which I will develop from a more practical rather than technical approach, we must always remember and accept that share prices do not only fluctuate according to their technical merits.

The vagaries of the often conflicting influences of supply and demand lead to share prices fluctuating with, sometimes, little or no obvious explanation.

By way of a very quick example, shares in one of the Premier League’s most under-rated football teams, Sheffield United, have risen in recent years from just 6p to 30p in spite of consistent financial losses before falling back to their current level of only half that recent peak in spite of promotion to the Premier League and continued exceptional financial management by a very capable board of directors.

It begs the question, then as to whether the share price went up too far last year or has fallen too far since.

This happens to many shares and I will try to give a little more insight into some of the reasons in my next article.


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