A picture can tell a thousand words and a recent AIB share price graph paints a dramatic picture, writes Rory Gillen.

The sell-off in the Irish market, among financial and construction stocks in particular, has been severe.

Although the major Irish financial stocks have minimal exposure to the US subprime issues, investors are concerned about the likely impact of a sharp correction in Irish property activity and prices.

I do not wish to rehash or argue these issues any further here, but rather highlight that the market consistently overreacts to both good and bad newsflow in the short term, as investors are driven to excess sometimes by greed, and at other times by fear.

But, in the medium term, investors are very rational and reward a company and its share price for the increase in business value created through the growth in earnings and cash flows.

The graph shows the progress of AIB's share price and its earnings from 1994 to the current date.

When looked at on a short-term horizon, AIB's share price wanders all over the place as the price responds to demand and supply considerations. But in the medium to long term, the share price follows the progress in earnings.

It is the same with property prices. Over time they move up in line with the growth in personal incomes in society.

Obviously, interest rate movements have a once-off impact on asset values but, for the sake of simplicity, we will avoid that debate here.

In 1999, corporate tax cuts and unfounded rumours surrounding the possibility of AIB being taken over saw its share price rise well above the level justified by the earnings trend.

Once these rumours died away, the fundamentals reasserted themselves and the share price gravitated back around the earnings line.

Currently, investor wariness about the likelihood of a decline in AIB's earnings in 2008 has seen the share price disconnect significantly from the earnings trend.

The sell-off has been so severe that it would take a 40 per cent decline in AIB's earnings from here, together with the assumption of little or no recovery thereafter, for the current sell-off to be justified.

Now that is an extreme case to argue. Yet that is exactly what investors have priced in.

Yes, there is uncertainty over earnings as we look into 2008, but private investors should avoid falling under the market's spell.

For it is just as likely that, when we look back in six to 12 months' time, the current market reaction to the problems unfolding will be seen in an all too familiar light - another case of extreme overreaction not justified by the fundamentals.

Rather than trying to second-guess the likely outcome, it may be better simply to focus on the value on offer now.

Based on 2007 earnings of 208 cent, which look to be in the bag, AIB currently offers an earnings yield of 16 per cent from which it pays a dividend of 79 cent or a dividend yield of 6 per cent - a dividend that is covered 2.6 times by earnings.

Now that's a huge "margin of safety".

In addition, the dividend yield on offer is a full 2 percentage points above current European Central Bank interest rates of 4 per cent.

A starting dividend yield of 6 per cent plus even modest annual growth of 4 to 5 per cent in that dividend suggests annual returns of 10 to 11 per cent at a minimum over the medium-term for current buyers of AIB's shares.

Rory Gillen is director of Merrion Capital