Skip to main content

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

Comments

Post a Comment

Popular posts from this blog

The Wrong Forecaster

Dear Speculators, The gloominess of the Nigerian economic outlook has significantly knocked down the prices of some financial assets but the real value of some of these assets have been mildly affected. While recounting the economic misfortune that has befallen the country in the last two years is inevitable, dwelling on the past is a perfect time wasting activity. Luckily, investment is forward looking and not regressive thinking. The past is a great indication of the future but not a mirror for prediction. The randomness of the world ensures that yesterday looks at least slightly different from tomorrow. And if we have learnt anything from the history books, it is that good things do not last forever and bad times always have an end. Life is by definition cyclical. The key questions to ask before buying or selling any financial asset is; will the current economic situation last forever? Will the inflation rate remain in double digits over the next 5 years? Will the Nai...
Post a Comment
Read more

ECOWAS: The Silent Opportunity of a Weaker Naira

Dear Speculators, The catastrophic collapse in the value of Naira in 2016 has brought more bad news than good news to Nigeria. This has come at a time when currency manipulation in Japan, China and Switzerland to purposely erode the value of their currency in order to gain trade advantages has angered many foreign governments especially America. Britain was lucky to have had the Pound devalued by the financial markets in the aftermath of the Brexit to the delight of the Bank of England whom like many other Central Banks in the western world are now inflation seekers. But not Nigeria, we don't need a weaker Naira, at least not now. Unfortunately, the drastic fall in the oil price, current account deficit, lower foreign external reserves and withdrawal of foreign investments from Nigeria has dragged the Naira about 58% lower since its January levels at the interbank market. This has almost doubled the rate of inflation in the last one year as imported products make up a si...
Post a Comment
Read more

Concise Comprehension of The Daily Market Report

Dear Speculators, Everyday we are bombarded by the latest financial news, the closing share prices, the top gainers and losers, the volume traded and the market capitalization. Most of the news sound like gibberish to those who don't understand what the numbers mean and it sometimes causes panic to those who know how to read the market reports. It is for this reason that I wish to take you gradually through digesting the news and acting on information. Share prices simply reflect the equilibrium value of a financial asset as a result of the forces of demand and supply and may not reflect the true or intrinsic value of that asset at a particular point in time. The share price may go up or down depending on the demand and supply of that particular stock in the market. Any change in share prices is triggered by either a large demand or large supply of that stock in the market. The biggest influence on prices is the sentiments of the institutional investors and pension fund ...
Post a Comment
Read more