Investor Ratios measure how attractive public limited companies are for current and future shareholders to purchase. P/E (Price/Earnings) is one of them.
Buying shares in a company has the potential for two kinds of financial return. Capital gains can be made when the share price is rising – you buy when cheap and sell when expensive. In addition, companies pay annual dividends to shareholders – you get a part of the firm’s profit (unless profits are too low or losses are made).
Investor Ratios give an indication of the prospects for financial gain from both of these sources.
What does P/E (Price/Earnings) measure?
P/E (Price/Earnings) is ratio between Share Price and EPS (Earnings Per Share). It compares Share Price with EPS (Earnings Per Share).
P/E (Price/Earnings) measures how much share price is relative to earnings after TAX for one share.
P/E (Price/Earnings) measures how much price shareholders need to pay for USD$1 of current net earnings per share. And, how long shareholders need to wait at the present earnings level to receive payback on their investment in one share.
How to calculate P/E (Price/Earnings)?
The figures for working out P/E (Price/Earnings) can be found in Profit and Loss Account (P&L Account), The EDGAR System, the primary system for companies to file documents for The SEC (The U.S. Securities and Exchange Commission), Yahoo Finance, or any reliable stock broker:
| Share Price | |||
| P/E (Price/Earnings) = | ━━━━━━━━━━━━━━━━━━━━ | ||
| EPS (Earnings Per Share) |
Example for P/E (Price/Earnings)
A company that earns USD$4 per one share with Share Price of USD$100 has P/E (Price/Earnings) of 25. P/E (Price/Earnings) of 25 implies that shareholders need to pay, or are willing to pay, USD$25 for each USD$1 of current net earnings per share. P/E (Price/Earnings) of 25 means that shareholders will need to wait 25 years at present earnings levels to receive payback on their investment in one share.
Comment
P/E (Price/Earnings) is expressed as a number in currency.
P/E (Price/Earnings) is a widely used metric to determine whether a stock is a good investment when it comes to Capital Gains. Investors will gauge whether the price is relatively speaking high or low compared to the past, and compared to other companies in the same industry. It is because investors may have different levels of optimism about the prospects for different industries. It would not be useful for investors using P/E (Price/Earnings) as a basis for their investment decisions to compare the P/E (Price/Earnings) of a technology company with a high P/E (Price/Earnings) to a utility company with a low P/E (Price/Earnings). Each industry has different growth prospects.
High P/E (Price/Earnings) means that investors need to pay high price for USD$1 of current earnings. It also means that they are expecting higher earnings growth in the future compared with companies with a low P/E (Price/Earnings) ratio.
Low P/E (Price/Earnings) means that investors need to pay low price for USD$1 of current earnings. It also means that they are expecting lower earnings growth in the future compared with companies with a high P/E (Price/Earnings) ratio. A ratio results of 1, for example, would mean that investors had very little confidence in the future earning power of the company.
How to improve P/E (Price/Earnings)?
Improved P/E (Price/Earnings) means lower P/E (Price/Earnings). Investors will now pay less price for owning a certain amount of earnings after TAX for one share. Shareholders will also need to wait less time at present earnings levels to receive payback on their investment in one share.
1. Lower Share Price. Prices in any market are determined by the laws of supply and demand, market momentum, customers’ mood and the amount of speculation. Therefore, share price of the company stock will mainly decline under the following conditions:
- Laws of supply and demand. Business performance deteriorates and investors choose to invest in better businesses. There are several signs which indicate that the business is performing worse than before. It has:
- Worsening Profit and Loss Account (P&L Account). Sales revenue is declining. Costs are rising, Interest payments are rising, TAX payments are high. And profits are declining or the business is making a loss.
- Weak Balance Sheet. Cash evaporates, debt grows, inventories increase, debtors increase and Liabilities equal to 100% of Equity (Short-term Liabilities + Long-term Liabilities – Cash = 100%).
- Troubles with Cash Flow. Cash Inflows are declining. Cash Outflows are increasing. Net Cash Flow is declining or its negative.
- Market momentum. When the overall market sentiment supports selling with following market trends. Negative momentum indicates a bearish trend pushing the price downward following others (so called herding strategy).
- Investors’ mood. In general, prices positively correlate with investors’ mood with higher asset prices linked with better mood. A negative mood state will make investors more pessimistic about the future, therefore less willing to make risky investment decisions, or pay higher prices. Numerous events can impact social mood such as war, natural disasters, health epidemic, the weather, results of important sporting events, etc.
- The amount of speculation. All the speculation that is happening against the company. Financial speculation of stocks that can drive stock price down includes selling and short-selling. With sellers of stock, they will sell, if they speculate that the market will decrease in value, or if a company’s stock price will decline.
MOOD is composed of two dimensions: pleasantness and activation. These two dimensions form four quadrants of mood: high activation and pleasantness (enthusiasm), low activation and pleasantness (calmness), low activation and unpleasantness (depression) and high activation and unpleasantness (anxiety).
2. Higher EPS (Earnings Per Share). The company achieves higher EPS (Earnings Per Share) under two conditions:
- Higher Net Profit After Interest and TAX. The company should increase Sales Revenue as well as decrease the cost of production Cost of Goods Sold (COGS), decrease Expenses (Overheads), decrease Interest payments on debt and decrease TAX obligations to the government. Increasing Net Profit After Interest and TAX will increase EPS (Earnings Per Share).
- Less Shares Outstanding. The company, especially companies rich in cash, should buy back its own shares from the owners. Decreasing the Number of Shares Outstanding will increase EPS (Earnings Per Share) as more Net Profit After Interest and TAX will be now allocated to each common share.
Investor Ratios are of particular interest to current shareholders and prospective investors who need to assess the rate of financial return on shares and risk when making an investment to buy the shares.
