Put very simply a share is best valued by measuring its PE ratio. This compares its price with its earnings per share (Price/EPS=PE). The reciprocal of the PE is known as the earnings yield (EY) and can be compared directly to the dividend yield on a bond. However there is more risk involved in a share's earning yield because earnings are not guaranteed from one period to the next and they may fall or rise abruptly. Long tern investors look for shares whose earning per share have a long record of steady increase. Owning these shares has an advantage over bonds because the yield will rise over time.
A bit of an example should make things clearer. Lets imagine a company that makes a variety of foodstuffs and call it Munch Incorporated:
- It has a share price of $20 and its earnings per share are $1.
- Its PE ratio is 20 (20 divided by 1)
- The reciprocal of this is 5% (1 divided by 20 is .05, multiply this by 100 and you have 5%)
If we take an average of all shares on the market and look at the movement of their PEs we capture the movement in several measures
- Movement in bond yields. If bond yields fall then unchanging EY will begin to make shares look more attractive so prices will rise to bring EY back into line
- A general rise in earnings prospects brought about by, for example, a strong economy will shift sentiment and raise the expectation of earnings and EY in future. This anticipation will raise prices and reduce EY until the improvement in earnings become a reality
- Extra cash coming into the stock market because of the printing of money or because investors become over exuberant about earnings prospects will all raise prices and reduce EY