Sunday 1 November 2009

Are Hong Kong shares worth their high prices?

Investors should do the maths on yield, P/E ratios

2 comments:

Guanyu said...

Are Hong Kong shares worth their high prices?

Investors should do the maths on yield, P/E ratios

Stephen Vines
01 November 2009

Hong Kong share prices, although currently faltering, have reached a level where they are being described as “dangerously overheated” or, as optimists would put it, “finally realising their potential”. However, both optimists and pessimists agree that the local market today is far from normal and that Hong Kong share valuations are moving out of line with other markets.

This is a good time to consider a question shareholders rarely ask, namely: how much are their shares worth? The basic answer is simple: shares are worth whatever price they have reached in stock market trading. But there is another way of looking at this that goes to the roots of equity investment.

A person buying shares becomes a member of a company and, as the name implies, is entitled to a share in its profits. He also takes on the burden of loss. Hence, investors are advised to pay closer attention to the value of their shares.

This requires judgment and there are two most commonly applied ratios for measuring value: yield and price/earnings ratios.

The yield figures, presented alongside stock price listings, should properly be described as “dividend yield per share” because they do not reflect earnings, merely the amount of profits the company directors decide to distribute to shareholders.

In Hong Kong companies tend to distribute a high percentage of their profits because the major shareholders derive the bulk of their income from dividend payments, as opposed to salaries which are subject to taxation.

Therefore yields on Hong Kong shares are generally higher than in many markets, not because companies are more profitable here but because they retain a smaller proportion of their earnings.

This is why, particularly in Hong Kong, greater attention is paid to the P/E ratio - the current market price divided by earnings per share for a 12-month period. High P/E ratios indicate that either investors believe that past earnings are modest in comparison to earnings to come or simply that such is the demand for the shares that their price has lost all reasonable relationship with value.

A company trading on a P/E ratio of say 40 or 50 - hardly unknown in Hong Kong and less so in Chinese markets - is telling shareholders that they are paying some 40 times the amount of the money the company is making in a given year.

To put this in perspective: when entire companies are being valued for sale, buyers will rarely pay more than single-digit multiples. Indeed, any company that is, for example, making HK$100 million per year and manages to sell itself for HK$500 million is generally considered to have achieved a good price for the sale.

Meanwhile, shareholders are prepared to pay 10 times or even more for their stake in companies listed on the stock exchange.

Hong Kong shares are now trading on an average P/E ratio of about 20 times. This is not only way above normal levels that prevailed in this market but high compared to others. Traditionally, Hong Kong’s P/E ratios have been below others in the region and modest compared to major markets, with the exception of the largely domestic Japanese stock exchange.

Guanyu said...

International investors have long placed a higher risk premium on the Hong Kong market because of uncertainties over China’s intentions towards the territory. That uncertainty has now been removed in the minds of most investors (whether this is so in reality is another question), allowing the special administrative region to enjoy a more “normal” risk profile.

However, current trading conditions are far from normal. “Normal” here usually means P/E ratios of about 9 to 13 times but a year ago, in the depths of the financial crisis, average multiples sunk to about 7 times. Today they are even above the overheated mainland Chinese markets and well above those which prevail in London and New York.

The situation with yields is also abnormal. Average yields in the Hong Kong market today range between 2.5 and 3 per cent. This compares with almost 7 per cent a year ago and places Hong Kong at the bottom of the league table of major internationally traded markets.

There are many other ratios which give an idea of the absolute and relative values of shares; annoyingly, these ratios are not generally published but often crop up in reports by investment analysts.

The one which is most telling shows multiples of book values - in other words, the value of a company’s assets minus its liabilities.

The Financial Times columnist John Arthurs recently called attention to a remarkable development in which the average book value multiples of companies in emerging markets has overtaken that of companies in the developed markets. The former are now trading on an average multiple of 2.1 whereas the latter have fallen to 1.75. To put it another way, shareholders in emerging markets are prepared to pay twice the net value of companies for their shares.

Until recently, emerging markets shares were “cheaper” in this respect because they were considered to be carrying greater risk. However, the events of October 2008 seem to have persuaded investors that risk is all too evident in developed markets.

But it remains a fact that it has become much cheaper to buy shares in high-quality companies with a long track record in developed markets, relative to companies in emerging markets that are growing fast, but not necessarily in a sustainable way.

The emphasis on value is often lost in the fog of investment excitement. That is why there is an enormous industry among so-called “chartists” who track market behaviour and identify pressure points when markets are likely to rise or fall.

In this context, much attention is being paid to the doubling of the Hang Seng Index in the past 12 months and the probability that a rise of this kind will be followed by at best a dip or more likely a plunge.

Whether that has more to do with evaluations of market behaviour or an analysis of corporate value remains to be seen.

Stephen Vines is the author of Market Panic - Wild Gyrations, Risks and Opportunities in Stock Markets