The "Relative Value" Ratio

Einstein's theory of relativity can be applied to stock market investment decisions too. In economic terms it is called "opportunity cost", as investing in one company costs you the foregone return you would have had from investing in another company.

So how do you make the most of your decision and minimize your opportunity cost?

When deciding between investing in a number of options on the market, it is always important to have a comparable ratio. As the stock markets grow and because all the listed companies fundamentals differ so widely, the use of a comparable ratio becomes increasingly important when making informed investing decisions.

I have come up with what I feel is a robust comparable ratio (even across sectors). Let's call it the "Relative Value" ratio.

The ratio aims to seek the highest dividend yield with the highest undervalued growth rate.

For each company perform the following basic steps:

1. Calculate the Price Earnings (PE) ratio of the share. This is the following "Share Price" divided by "Earnings per Share"

2. Calculate the long-term growth (G) rate of the company. This single number will be the hardest to get and involves significant research and judgment. If you are not confident enough to forecast your own one, then perhaps call your broker and ask for his one or use the brokerage census growth rate.

3. Calculate the Price Earnings Growth (PEG) ratio. This is the "PE" divided by the "G".

4. Calculate the Dividend Yield (DY) of the share. This is the historic dividend paid divided by the share price.

5. And finally, calculate the Relative Value of the share. This is the "Dividend Yield" divided by the "PEG".

Can you see how the lower a stock's PEG is, the less you are paying per unit of growth of the company...?

Also, the higher a stock's DY is, the higher yield you will be making from the dividend flow from your investment and the the higher a stock's DY is and the lower its PEG is, the higher the Relative Value ratio will be.

Let's take an example: say you wanted to invest in either Standard Bank (SBK) or ABSA (ASA) on the JSE Securities Exchange (the South African stock exchange).

Standard Bank has a PE of 8.38, a DY of 3.29%, and a forecast growth rate (per brokers consensus) of around 15%. Thus Standard Bnak's Relative Value ratio is 6.98 (= (3.29%) / (8.38 / (15% x 100))).

ABSA has a PE of 6.81, a DY of 5.86%, and a forecast growth rate (per brokers consensus) of around 13%. Thus ABSA's Relative Value ratio is 11.19 (=(5.86%) / (6.81 / (13% x 100))).

Therefore it looks like ABSA is the best option. It appears that it will give you a better yield on your investment in terms of a balance between dividend and capital growth.

In closing, although the Relative Value ratio is a useful tool in an investor's arsenal, it does not replace the need to research and understand each company's fundamentals prior to entry. There are many assumptions that the Relative Value ratio uses in its goal of comparative investment analysis, and the most significant one is the use of historic information. Remember that the past is not always a reflection of the future and always use your own judgment when coming to a decision.

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