In terms of the anticipated earnings of the companies, shares are generally classified on the basis of their market price in relation to one of the following measures:
- Price/Earnings Ratio is the price of a share divided by the earnings per share, and indicates what the investors are willing to pay for the company’s earning potential. Young and/or fast growing companies usually have high P/E ratios. Established companies in mature industries may have lower P/E ratios. The P/E analysis is sometimes supplemented with ratios such as Market Price to Book Value and Market Price to Cash Flow per share.
- Dividend Yield for a stock is the ratio of dividend paid per share to current market price. Low P/E stocks usually have high dividend yields. In India, at least in the past, investors have indicated a preference for the high dividend paying shares. What matters to fund managers is the potential dividend yields based on earnings prospects.
Based on companies’ anticipated earnings and in the light of the investment management experience the world over, stocks are classified in the following groups:
- Cyclical Stocks are shares of companies whose earnings are correlated with the state of the economy. Their earnings (and therefore, their share prices) tend to go up during upward economic cycles and vice versa. Cement or Aluminium producers fall into this category, just as an example. These companies may command relatively lower P/E ratios, and have higher dividend pay-outs.
- Growth Stocks are shares of companies whose earnings are expected to increase at rates that exceed normal market levels. They tend to reinvest earnings and usually have high P/E ratios and low dividend yields. Software or information technology company shares are an example of this type. Fund managers try to identify the sectors or companies that have a high growth potential.
- Value Stocks are shares of companies in mature industries and are expected to yield low growth in earnings. These companies may, however, have assets whose values have not been recognised by investors in general. Fund managers try to identify such currently under-valued stocks that in their opinion can yield superior returns later. A cement company with a lot of real estate and a company with good brand names are examples of potential value shares.