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All that Glitters is not Gold



Dear Speculators,

A lot of people wrongfully determine cheap stocks by the naira value of its shares. We on the other hand believe Price to Earnings ratio to be a better determinant of a cheap or expensive security. If the PE ratio is unreasonably high, it is too expensive and if it is unreasonably low, it is very cheap. We use the word unreasonable because like Prof Bruce Greenwald of Colombia University pointed out, we live in a world of two extremes. We always believe we are 100% right so when we are wrong, we are 100% wrong, nothing less. As we act on our beliefs, we may drive prices either too high or pull prices too low such that on the average we are both right and wrong.

To a large extent, the naira value of a share unit depends heavily on how a company chooses to dilute ownership. For example Company A worth 10 billion naira may sell 100 million shares valued at 100 naira per share and have earning power of 50 naira per share such that the PE ratio is only 2. Company B on the other hand valued at 20 billion naira may choose to sell 1 billion shares valued at 20 naira per share but have earning power of 4 naira per share such that its PE ratio is 5. At 1st glance it appears that the nominal value of company B stocks are cheaper than company A stocks because company A shares are 5 times higher than company B shares but in reality, company B shares are more expensive than that of company A because the return on equity of company A is much greater than that of company B. Company A has a lower PE ratio than company B so we are paying more for a single share unit of Company A but the return is 2.5 times greater than the return at Company B.

PS: Low PE ratio may also mean high risk or high leverage business so it is necessary to research on the company before purchasing its shares. There may be a good reason why the market priced it so low. This sort of analysis is only relevant for companies in the same industries or similar lines of business. All that Glitters isn’t Gold!

Signed:
Emeka Ucheaga,
Managing Partner,
Emeka Ucheaga Advisory

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