To be able to  identify the opportunities that exist within the Australian stock market, it’s essential to understand it in more detail then most other investors.

In terms of the size of the market, the total value of the Australian Securities Exchange (ASX) sits around $2 trillion. 

This is the 16th largest in the world with the New York Stock Exchange (NYSE) coming in at number with a total value of $32 trillion.

It’s also important to understand the investor relationship with the market. In places like Australia and the UK, investors are very dividend focused. 

They want to be rewarded by the companies that they invest in with consistent dividend payments.

On the other hand, countries like Japan and the United States have investors that are very much focused on earnings and growth.

 

As a result, Australia and UK have higher dividend paying companies with lower earnings ratios. In Japan and the US, companies have higher earnings ratios and lower dividend payments. 

Understanding the P/E Ratio

The other thing to get clear on is understand exactly what the price to earnings ratio means for investors. The p/e ratio highlights how much an investor is willing to pay for $1 in earnings. 

So, if a company has a p/e ratio of 35, it means that investors are willing to pay $35 for every $1 of earnings for that business.

It also reflects how long it will take to recoup your original investment. With a p/e ratio of 10, it will take you 10 years to get your initial investment back. That’s why the lower the p/e is generally better.

But I find the following example is the best way for people to really understand the price to earnings ratio in great detail.

Let’s say that you have two identical houses. They are in the same street, side by side. Both properties are selling for $500,000. Property A, has an annual rental return of $50,000 whilst property B, has an annual return of $25,000.

As an investor which property do you go for? Of course, you pick property A.

Why pay $500k and only receive $25k in rent when you can receive double that for the property next door.

This is exactly how the p/e ratio works! Property A has a p/e of 10 and property B has a p/e ratio of 20.

As an investor, you could pay $600k for property A and still have a better return then property B. If a bidding war took place and property A was listed for $500k but sold for $600k, it’s a 20% capital increase.

Again, this is exactly hoe the p/e ratio works for stocks

It Goes Beyond Individual Stocks

I’ve found that some investors are not aware of the fact that you can apply the p/e ratio to an entire sector, industry or market.

I’ll be using the p/e ratio and earnings yield as a measurement to determine if the Australian Stock Market is overvalued or undervalued.

At the time of writing, the ASX has a P/E ratio of 17.13. Now, we know that on its own that number doesn’t mean a lot. To give it context we need to look at a historical context. Over the past 40 years, the average p/e ratio for the ASX is 15.

Keeping it as simple as possible, we can say based on the p/e ratio that the market is in fact still overvalued. But that doesn’t mean the market will correct instantly. 

On a number of occasions throughout the 40 years, we can see the p/e going over 20 and pushing 25.

For me, 20 is the key number. As we can see over the past 40 years, when the market gets over 20, it finds it’s way backdown to the long term average of 15. 

On 3 occasions it does continue to go above this number pushing upwards of 25. But from a risk to reward point of view, it is inherently more risky buying stocks when the p/e ratio is above 20 due to the law of diminishing returns.

The other really interesting point to note is the earnings yield trend for the ASX. The long-term earnings yield for the market is 7%. 

But the earnings yield hasn’t gone above that level since November 2012, almost 8 years ago.

The reason that the earnings yield is important is that it allows companies more flexibility and choice in terms of what they want they want to do with their earnings.

There are basically only 3 things that a company can do with its earnings

      Grow the business

       Pay down debt

       Pay a dividend

 

If you are investing in a company that has high levels of debt in a low earnings market, they won’t be growing the business or paying a sustainable dividend as the debt will need to be serviced first. 

This brings me onto my next point. Dividend payments. As I mentioned earlier in this article, Australia is a dividend paying nation. In fact, whilst earnings has decreased from 7% to 5.8% since 2012, the dividend yield has increased from 4.49% to 4.71% over the same period.

 

Again knowing that there are only 3 options a company has with its earnings, we can see that many are opting to pay a dividend to shareholders. That means that growth and debt have taken a back seat.

Now that you know the averages and base line information on these 3 areas, you can find deals within the market. The ASX is still slightly overvalued from a p/e point of view. 

Finding a company that has earnings yield over 7% would be a great start in finding value. You’d then want to see how sustainable these earnings have been.

 It’s a good sign if it has been over the 7% mark for the past 5 years and even better if it has been 10. 

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