Investigating the relationship between intrinsic value and the price of industrials on the JSE

Abstract

Given the lacklustre domestic growth forecasts and a slowing global economy, fund managers and investors need to focus on and understand what it is that drives the local stock market prices and find measures to evaluate investment opportunities. The availability of various financial measures complicates investor decisions even further as the debate on which metrics are most important continues. This study compares the frequently used price-earnings-to-growth (PEG) valuation with well documented value-based metrics, Economic Value Added (EVA™) and Residual Income Model (RIM), in their ability to identify over/under priced stock in the different stages of a bull market and a bear market for industrial companies listed on the Johannesburg Securities Exchange (JSE). A quantitative research approach was used to indicate whether or not relationships exists between EVA™, RIM and PEG valuation multiples and 1-year forward share price growth during different market periods. Overall, the evidence suggest that EVA™ does not perform well in identifying mispriced stock during any of the market periods. Furthermore it suggests that during a bear market and the first couple of years of a bull market, fundamental valuation models such as RIM outperforms heuristic models such as PEG in identifying mispriced stock, whilst in the latter parts of a bull market the contrary is true. Result also indicate that using EVA™, RIM and PEG multiples to make investment decisions could assist fund managers to outperform the market.