Abstract
M.Com. (Investment Management)
The relationship between leverage and normalised diluted trailing P/E ratios of firms listed on the FTSE JSE Top 40 Index was analysed. This study makes use of VAR analysis and VECMs to analyse whether there is a long-run relationship between the two variables. This study aims to provide insight on: (1) the distribution of the leverage and P/E ratios; (2) what influence the business cycle may have on leverage and P/E ratios; (3) the nature of any long-run relationships between leverage and P/E ratios of companies with respect to their specific sectors; and (4) the foundation for further research into the incorporation of leverage into valuation metrics. The data were separated for the purpose of analysis into their applicable sectors. The sectors included for analysis were: Basic Materials, Consumer Defensive, Energy, Financial Services, Industrials and Technology. Where applicable, the nature of any relationship was analysed further through the use of impulse responses and variance decomposition. The analysis highlights the variation between different sectors and their metrics, and reaffirms the importance of analysing the sectors in isolation from each other. The most conclusive results were found within the Basic Materials, Consumer Defensive and Industrials sectors. The data within the Basic Materials and Industrials sector showed that the P/E ratio was more endogenous than leverage. Leverage settled at a higher equilibrium for the Basic Materials sector and lower equilibrium for the Industrials sector, post a shock to leverage. Shocks for both sectors will result in a lower equilibrium level for price and earnings. The P/E ratio for the Basic Materials sector settles back at its initial equilibrium and the P/E ratio for the Industrials sector settles at a new equilibrium. A long-run relationship was found within the Consumer Defensive sector, with leverage being the more endogenous variable. This study provides a basis for further research into the relationship between sector leverage and P/E ratios. Additional analysis into relationships between core firm fundamentals and firm value would be beneficial. It also aims to provide a foundation for the incorporation of the findings of this study into the construction of a new or adjusted P/E ratio that can be used comparatively between different sectors of the JSE.