The Essential P/E. Keith Anderson
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had experienced, so the gap between the two valuation methods was not as marked.
Relatively uninformative UK company accounts did not help: consolidated accounts (reporting the group’s overall position rather than individual companies within the group) were not compulsory until 1948, and even something as basic as turnover did not legally have to be disclosed until 1976. As a result you could find analysts in the same research note covering US stocks in an industry by looking mainly at their P/E, but the UK stocks in the same industry by mainly considering their DY.
It was not until 1965 that UK investors really caught up with the US in their use of valuation ratios. The introduction of corporation tax in that year meant that companies and individual shareholders were finally treated as separate taxable entities. Until then, companies had paid income tax on behalf of their investors, who might have to pay further tax depending on their level of income. Thus it was difficult to estimate company income after company taxes but before personal taxes. By 1966 The Economist was already valuing many UK companies using their P/Es.
The P/E today
Amongst practical investors the P/E has maintained its popularity since then. However, there are two areas in which the P/E has been eclipsed in recent years. Interest in it from finance academics has been limited since Eugene Fama and Ken French decided in the early 1990s that price-to-book value was a better indicator of value stocks and dropped the P/E from their now widely popular three factor model. (See later chapter.)
The other time the P/E has become little used has been during stock market bubbles. This is ironic considering that the P/E itself only came to prominence during the 1920s’ boom in the US. Some extraordinary P/E ratios occurred during the dot.com mania: America Online reached a P/E of 275 and Yahoo a P/E of 1900.
Extraordinary P/Es in the hundreds or thousands are telling investors that they are building castles in the sky, but during bubbles that is precisely the message that investors don’t want to hear.
Chapter 2. Earnings
Before we can cover the P/E itself, we should first define its more complicated component: earnings. This chapter covers the basics of the different ways in which earnings and then earnings per share (EPS) can be defined. I move downwards through the profit and loss account and discuss the different figures as more and more costs are deducted from profits. The discussion is purposely kept general here; for a practical example, see the later chapter on Haynes. I do not intend to give a detailed explanation of company accounts, as many other books do this; I cover only the components of the earnings calculation.
From sales to operating profit
The basics need little explanation.
A company produces goods or services and sells them; the amount the company receives here is termed the sales (or turnover, or revenue). From this figure of sales we need first of all to deduct the cost of the items sold to calculate the gross profit.
However, we have not yet reached the first figure that counts as earnings, because many expenses must be taken into account on top of raw materials, such as staff costs, IT, rent and so on. Other notional expenses, such as depreciation and amortisation, are also deducted. These are not necessarily items that have caused us to actually spend any cash this year, but they need to be deducted regularly from gross profit in any case. Declared profits would be excessively variable if large occasional expenditures on capital items were recorded as they happened. There is anyway a separate Consolidated Cash Flow statement.
‘Earnings’ as a word on its own is in fact a rather ill-defined catch-all term for any of the profit figures we now cover. The initial figure for earnings is the difference between revenue and the total of these costs – basically all the costs of the company excluding finance charges and tax. This initial earnings figure is called operating profit.
Towards the P/E’s earnings figure
Operating profit is the highest figure up the profit and loss account that is referred to as ‘earnings’. However, there are two unavoidable costs of running a business that still remain to be taken out: interest paid to service loans, and tax. Subtracting interest paid gives profit before tax. Finally subtracting tax paid gives profit from continuing operations. (Details of any discontinued operations will appear in a separate column in the profit and loss account.)
Now all the necessary deductions have been made to the profit, a ‘clean’ figure is available to distribute to shareholders or into the company reserves. It is this profit from continuing operations that is used in EPS calculations.
EBIT and EBITDA
These ungainly acronyms have become increasingly popular in recent years. EBIT stands for earnings before interest and tax, and EBITDA for earnings before interest, tax, depreciation and amortisation. There are times when they may legitimately be used. For example, EBITDA is often used in loan covenants, partly because the bondholders are not concerned about tax payments – interest payments are made before a company’s tax liability is calculated.
However, it is hard to avoid the impression that EBIT and EBITDA have become so widely quoted because they make every company’s earnings look better. It is always a bad sign to come across a company proudly quoting its EBITDA in the first few pages of graphics in its annual report, instead of profit figures from further down the profit and loss account. Often a few seconds with a calculator will show that the company has little or no chance of ever making a real profit, because its amortisation charges more than wipe out the operating profit each year.
EBIT and EBITDA have been memorably if unkindly described as “look how much we could have earned if we didn’t have to pay our bills”. Interest on loans and tax are unavoidable costs of running a business and really should be taken account of. If the company sourced its capital from shareholders, instead of borrowing the money, then it would presumably have to pay dividends instead of loan interest. Tax is sadly unavoidable for us all, and does at least help provide a safe legal framework in which the company can operate. Depreciation and amortisation are even more basic expenses that have already been subtracted before the operating income is reported. As Warren Buffett asked: “Does management think the tooth fairy pays for capital expenditures?” I do not use EBIT or EBITDA further here.
Basic, diluted and adjusted EPS
Having calculated earnings with all necessary costs taken out, we can now move from the company level to the per-share level. EPS is calculated by dividing profit from continuing operations by the number of shares in issue. This is basic EPS.
However, the company may well have options grants outstanding to executives, and sometimes to employees too, which will vest if certain targets are attained. These give a higher number of possible shares in the future. Dividing profit by the number of all the shares that exist now or might possibly vest gives diluted EPS.
The figure often quoted in the financial press is adjusted EPS (also known as headline EPS). This uses earnings with exceptional items excluded – large, one-off costs such as the expense of closing down an unprofitable division. Unfortunately, the exact definition of what is classified as ‘exceptional’ varies by company – the company’s accountants have wide latitude over the accounting figures.
Historical, rolling and forecast EPS
Another possible dimension to the stated EPS figure is whether it is historical or forecast. Historical EPS is the simplest and is what has been covered above, i.e. the earnings stated in the company’s most recent annual report.
Rolling EPS is based on the latest available earnings information. In the UK, if the six-monthly interim report has come out, the earnings from the first