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When investing in shares, a major indicator to look out for is the price
earnings ratio - a similarly important indicator is earnings per share, and the
two are, in fact, intimately linked.
Before covering the subject of price earnings ratios, it is first necessary
to cover earnings per share, how it is calculated and what it represents.
Earnings per share or EPS is defined as:
A company's earnings divided by the number of shares in issue.
(The earnings figure used in this calculation is the 'profit after tax')
As an illustration, if the profits after tax for Fledge.co.uk are £2.5
million and there are 25 million shares in issue. The EPS will be £0.10
What is the significance of EPS? Well, the reason that EPS is such an
important indicator for investors is that unlike a profit and loss figure in a
set of accounts, which deals with historical performance, EPS is a very good
indicator to investors about a company's future potential. The most common usage
is to look at the trend of a company's EPS - what you are looking for is a
steady consistent growth. Don't forget that being profits after tax, EPS will go
towards re-investment in the company's future and toward paying shareholders
dividends etc.
When looking at an EPS figure, be aware that different company's may report
certain 'one off 'gains and losses that make up profit figures in different
ways, thus distorting the true figure somewhat. If, for example, a brewery
company sold off some of its freehold pubs, would it really be correct to
include these funds in the final profit figure alongside its 'core business'
profits?
If they termed this an 'exceptional profit' they could do so. Likewise, if
the sudden ban in smoking in their pubs had an immediate but temporary effect on
profits, would it be right to call this an 'extraordinary' loss and exclude this
from the profit figures? Fortunately, when EPS figures are reported in popular
periodicals, they generally have all 'one off's' stripped out.
Just to re-iterate, the main thing to be looking out for is steady,
consistent growth in EPS.
Price earnings ratio
Now that we have covered EPS, we can proceed to Price Earnings Ratio or PE
ratio and this is how it is calculated:
Current share price divided by EPS
As an example, if shares in Fledge.co.uk were trading at £5 and EPS was £0.25
then the PE ratio would be 20 (500p / 25p = 20).
What does this tell us and why do we need to know this? Well, it really
relates three main things:
I) It gives an indication as to whether we are receiving
good value if we buy the shares. Using the example above, if I buy a share in
Fledge.co.uk for £5 and it has a PE ratio of 20 and an EPS of £0.25, then it
would take me 20 years, receiving 25p dividend per year, for the share to pay
for itself (the share is trading at 20 x earnings).
Now, of course, nothing remains static…you would expect the EPS and the share
price to rise over the years and the company would never declare a dividend
equivalent to the full EPS figure anyway, so treat this as a 'loose' snapshot of
value at a particular time.
II) It indicates market confidence in the share. This is a
somewhat better use of the PE ratio. If the market is confident in a company's
prospects, it will be willing to pay a higher price for its shares than is
really justified by current earnings. Demand for the share will rise, and the
price will increase, at the same time driving up the PE ratio of the shares. As
a general indicator, it is safe to say that shares with high PE ratios of say,
20 and above, are perceived by the market as very good growth companies with
excellent prospects.
III) It is a measure of profits against similar companies in
the same sector. If you were looking to buy shares in say, the Banking sector,
you might well, compare PE ratios of the various Banks to see whether there was
any 'value'to be had before making your choice.
Remember, EPS and PE ratios are very useful measures for investors, however,
they should form only part of an overall analytical strategy.
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Dow Jones