Why Shares Are Still the Only Game in Town

Dear Reader,

Crypto investors were cheering over the weekend as the price of bitcoin once again broke through the US$10,000 mark.

Without doubt, bitcoin is the biggest and most well-known crypto. Just as the US dollar is to mainstream currencies, bitcoin remains the base against which other cryptos are judged.

Working out the value of regular money in your pocket is easy. We do that every day, whenever we purchase anything.

With cryptos, however, it is much more difficult. Using cryptos to purchase something is still in its infancy.

Even if you were to purchase something using crypto, you’re more than likely to convert it back into your own currency before buying it. By knowing the paper money value, you know instinctively whether something you are buying is good value.

A bit like cryptos, working out the value of shares is more than just looking at the price. If it were simply a matter of price, a company with a share price of $20 will always be worth 10 times the value of a $2 stock.

But as we all know, this is not how it works.

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What determines the true value of a stock

There are a myriad of other things that determine that true value. For a start, a share price doesn’t mean anything unless you know how many shares are on issue.

And the share price in isolation, doesn’t tell you anything about the performance of the company. That $2 stock might be way better proposition than a $20 stock.

To help, analysts have created dozens of different ratios to help gauge a stock.

Perhaps the most quoted is the simple P/E ratio. That is, the ratio between the share price and the earnings per share.

Because of the direct correlation between the two, it is something you can apply to any stock. Investors use it ultimately to determine whether a stock is under, or overvalued.

The P/E ratio in itself, however, doesn’t provide all the clues. It merely forms a basis on which to compare.

As we discussed in a previous column, Commonwealth Bank of Australia [ASX:CBA] trades on a P/E of 17.55. That’s just a smidge below the market’s overall P/E of 18.42.

Does that tell us much? Perhaps…but maybe not a lot. You would expect a high-yielding mega-cap stock to match — if not slightly underperform — a market hitting all-time highs.

It’s only when we compare CBA to its three main rivals that we get a truer picture.

Australia and New Zealand Banking Group [ASX:ASX] trades on a P/E of 12.53. While Westpac Banking Corporation [ASX:WBC] and National Australia Bank Ltd [ASX:NAB] trade on P/Es of 13.21 and 13.98 respectively.

Clearly, CBA trades on a much higher P/E ratio than the other three.

That one lot of comparison tells us a whole lot more than the P/E in isolation. And infinitely more than the share price alone. (Although interestingly, CBA has a much higher share price than the other three as well — something that is not uncommon in the market).

Based on these P/E ratios, the market rates CBA as the strongest banking stock. The market sees it as having better growth and earnings potential, and higher resilience to external shocks.

And because banks form the cornerstone of many income portfolios, it shows a higher confidence from the market about CBA’s dividend. That is, the reliability of maintaining regular (and hopefully growing) dividends to its shareholders.

This also highlights the prism by which the market values stocks. That is, the expectation about what a stock can deliver.

At a time gone by, the market viewed banks as both growth and income stocks. Nowadays, they are clearly income only.

And because of that, dividend stability or growing (or simply not cutting) dividends are huge factors in how investors view bank stocks.

Compare that to arguably the greatest Aussie growth stock of a generation — CSL Ltd [ASX:CSL]. CSL trades on a whopping P/E of 48.3.

However, CSL trades on a miserly yield of just 0.9%. The way the markets value CBA and CSL is clearly very differently.

CSL’s history of outperformance over 25 years has placed a massive premium on the stock.

The obvious downside with such a high P/E — which applies to CSL or any stock — is if that same stock should disappoint.

It leaves it particularly vulnerable to a correction, if the fortunes of that stock (or broader market) should change.

The other oft-used ratio used to judge companies — especially income stocks — is the dividend yield.

Oddly enough, because the market places less faith in ANZ, NAB and Westpac’s ability to generate growth, profits, and dividends, they all trade on higher yields than CBA.

Because the market always looks to the future, their share prices have been beaten down in anticipation of lower growth, less profits, and smaller dividends.

Why investors remain invested in shares

With a high P/E stock being susceptible to any disappointment, it can be the opposite for stocks out of favour (usually trading on low P/Es). If earnings surprise even mildly, it can see a quick re-rating of the stock.

Dividend yields are probably the most common way investors gauge the performance of income stocks.

But again, they can’t be taken in isolation. When CBA first floated on the ASX, it traded on a handy yield of around 7%.

However, at the time, investors could have easily earned that and more by putting their cash in a term deposit.

Over time, however, CBA has turned out to be the way better investment. Not just because of its own growth trajectory, but because of the one thing that needs to be measured against any investment portfolio…inflation.

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CBA has been able to grow beyond the rate of inflation when measured over the period since its listing. While cash may have beaten inflation at times, it has come a very poor second to CBA…and the market.

It’s this relationship between inflation and interest rates that currently continues to drive the market ever upwards.

With interest rates at 0.75% in Australia (and negative in plenty of other countries), and an inflation rate of 1.8%, investors know that if they stay in cash, the value of their holding will continually diminish over time.

And that is why investors remain invested in shares. Until earnings slow down — the US is still tipped to grow at 2% this year — or interest rates rise to stem off still anaemic inflation, it is hard to see what will bring this bull market to a close.

All the best,

Matt Hibbard,
Editor, The Rum Rebellion
The Rum Rebellion