4 About shares and how shares are valued

Introduction

‘The market can stay irrational longer than you can stay solvent.’
John Maynard Keynes

How are shares valued?  There are probably as many views on this as there are people working in the investment industry.  But central to the art or science of valuing shares is forecasting a company’s earnings (defined below), which are conventionally expressed as earnings per share (EPS). Some companies pay out a portion of EPS to shareholders as a dividend. At a basic level, the price of a company share is what investors are prepared to pay at any particular moment in time for the forecast earnings stream of the company.  This is expressed simply as the price/earnings ratio – P/E – where P is the price per share and E is the EPS.  The level of confidence in and risks to the forecasts will be built into the price.  Based on this assessment, investors will buy the share, increase or reduce their holding, possibly sell it in its entirety – or maintain their position.

Forecasting EPS is difficult enough even for the best companies with strong track records.  Once you have taken a view on the likely  EPS for a company, looking many years ahead, you then endeavor to foresee all the possible factors that could have an impact on this and the probability of them occurring.  Strong, reliable earnings growth should be rewarded with a favorable company analysts’ rating, for example ‘buy’ or ‘strong buy’ or even ‘conviction buy’ – and a healthy valuation in terms of P/E ratio.

A company’s assets, including its intellectual property, also have a bearing, sometimes very strong, on its share price.  Analysts take a view on these factors and exert a strong influence in the market.  Their activities are discussed in some detail in Chapter 5 – Factors that influence share prices and Chapter 6 – The Market participants, facilitators and influencers.

The global economic context is crucial – most companies benefit from strong global growth, or from strong growth in their regional or sector context.  These factors affect both market sentiment and the realities of company earnings.  Interest rates also have an important bearing on share valuations.  If interest rates, which can provide a risk-free return, are on the rise, funds will flow from company shares to fixed interest instruments, causing a drag on share prices. […]