The Essential P/E. Keith Anderson
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Companies in particularly exciting high-growth sectors can also have very high P/Es of 20, 25 or more, even when there is no market bubble in operation. This is because of that future growth: if you are confident that a company will be growing strongly for years to come, then you should be prepared to pay a higher price now for a share of that growth. The high P/E is justifiable, provided that the expectation of long-term high growth turns out to be correct.
Historical and prospective P/E
Historical and prospective P/Es are calculated on the basis of the historical and prospective EPS:
Thus if a company earned 3p per share according to the most recent annual report and the share price closed at 24p yesterday, then the shares cost eight times a single year’s earnings and the company has a historical P/E of 8 (sometimes written as ‘8x’).
This is the most widely quoted figure, and the one that will be used in any academic research into how well P/Es predict share price returns, but it can be seriously out of date. In the worst case, the preliminary results for the company year just ended might be about to come out (and 120 days of grace are allowed before preliminary results must be published), but the EPS quoted is still that from the previous company year. So the historical P/E could be based on some items sold and costs incurred up to two years and four months ago.
A more up-to-date but less reliable P/E is the prospective P/E:
This is more up to date than the historical P/E because it is based on earnings expected by analysts over the current company year, i.e. sales currently taking place and costs currently being incurred. However, it is less reliable because it is based on analysts’ forecasts rather than accounting fact. Also, as explained in the previous chapter, the forecast EPS is only calculated if at least three analysts are following the company. Many small (sub-£50m market capitalisation) companies will likely only have their house analyst following them, and so do not have a prospective P/E. Historical back-tests of investment rules that want to use the full range of companies quoted on the stock market can therefore only use the possibly out-of-date historical P/E.
Example
Table 1: Inchcape and Haynes EPSs and P/Es, February 2012
Table 1 shows the different P/Es that can result. Inchcape’s earnings’ forecasts rise steadily over the next two years, so the P/E drops gradually. Haynes with a market capitalisation of £19m does not have enough analysts following it to have a prospective P/E quoted, so has only its historic P/E of 6.7.
Earnings yield and the E/P
Earnings yield is simply the inverse of the P/E, expressed in percentage terms. It gives a figure analogous to the bond yield, except for the fact that the earnings go initially to the company, not the investor. (Dividend yield is more closely analogous, since the shareholder actually receives the dividends.)
If one share costing 24p gave 3p EPS:
The earnings yield (without the percentage format) is universally used instead of the P/E in academic research. There it is referred to as the E/P. This is not just because finance researchers love technical jargon: the P/E has a nasty discontinuity in it. A share price can never go to precisely zero but EPS can, so you want EPS as the numerator, not the denominator. Consider a company with a share price of £10 that made +0.1p EPS last year:
If the same company makes just a few pounds less and hence a 0.1p EPS loss:
The P/E has gone through a discontinuity as the EPS passes through zero when the E/P has not. This is likely to cause problems when assigning companies to portfolios based on their P/Es, hence the E/P is used instead. Many studies in fact exclude loss-making companies altogether: although a (negative) P/E can be calculated if a company makes a loss, it is intuitively difficult to think what a negative P/E means.
Chapter 4. Practical Calculation of EPS and the P/E from Company Accounts
We have now covered in detail the theory of how EPS and the P/E are calculated. Now we can put this into practice using a real-life example: Haynes Publishing, publishers of the famous motor manuals. For the sake of this exercise I shall evaluate the company in mid-2011 when its share price was 255p.
Profit
Haynes’ profit last year can be found in its latest annual report, available from the investor section of its website www.haynes.co.uk.
Figure 3: Extract of Haynes’ company report – profit and loss account
The top line of the income statement is revenue, i.e. Haynes’ total revenue from publishing from 1 June 2010 to 31 May 2011.
As we saw in the previous chapter, as we move down the income statement more and more costs are deducted, starting with cost of sales and followed by distribution and administrative costs. Further details of these costs are given in the notes to the accounts. This gives operating profit of £7,687,000 finance costs (loan interest) are then set against finance income (interest earned on cash and investments) to give profit before tax of £7,177,000. Finally tax is deducted, to give profit after tax of £4,749,000. This remaining profit is that attributable to shareholders (non-controlling interests represent the portion of profits in subsidiaries that is not held by Haynes Publishing Group). It is the £4,742,000 of profit attributable to equity holders of the company that is used to calculate the EPS figure used in the P/E ratio.
EPS
We now divide the profit attributable to shareholders by the number of shares to get the historic EPS:
A weighted average has to be used because companies often issue more shares during the year as part of their executive bonus scheme. This increases the number of shares in issue and so dilutes the earnings attributable to each existing share. Large-scale fund-raising by issuing more shares is much rarer.
In fact Haynes did not issue any shares in 2011, so the weighted average is the same as the number of shares at the end of the financial year. Haynes also spares us another complication, diluted earnings per share, as there are no options outstanding to executives or employees. Haynes’ diluted EPS is 29p, the same as its basic EPS.
The company has in fact already done this calculation for us in the bottom lines of the income statement. Haynes’ EPS is 29p, but we can check the basis of the calculation in Note 9 to the accounts:
Figure 4: Extract of Haynes’ company report – earnings per share
The P/E