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Sorting the 'p' from the 'e'

May 05 2010 11:05
When an investor decides to buy or trade in equities, that’s the first step.

That decision is probably also the easiest one. But how does an investor decide which shares to buy?

Some who lack the time or inclination to do their own homework might rely on advice from an independent financial adviser or stockbroker.

Nothing wrong with that – as long as you make sure you’re getting wise counsel.

How to get sound advice

Look for possible conflict of interest: does the person giving the advice have close ties with a particular company?

As a rough guideline, also cross-check that the directives you’re receiving correspond with what’s being written or broadcast in the financial media or on websites.

Advice that’s most often not good to act on is what you hear around a braai on a Sunday afternoon.

It’s a well-known finding in investor psychology that people only tend to talk about the successful trades they’ve made.

When they’ve lost money on a share, they keep quiet.

But assuming the investor wants to do all the share selection on his own, what are the basic tools that can be used?

Financial ratios can be useful – but also very misleading.

Use ratios, but beware

Most widely used is no doubt the price:earnings or p:e multiple, also called the earnings multiple.

It’s simply the market price of the listed company (indicated in the daily financial press or at various sites online) divided by the company’s earnings per share (EPS), which is the company’s taxed profit – typically, the attributable earnings line on the income statement in the latest annual report divided by the number of ordinary shares in issue.

It’s then expressed as a number: for example, company A has a p:e of 10 times and company B a p:e of 15 times.

Assuming the two companies keep growing earnings at a constant rate, what the p:e indicates is that it would take company A 10 years to earn an amount equal to its market value and company B 15 years.

Broadly speaking, a higher p:e indicates a company is growing faster than a company with a lower p:e.

Investors are therefore prepared to pay more for the higher growth stock.

The implication in the example above is that company B is more expensive than company A.

However, that’s a generalisation, assuming a clean EPS number. From here on p:e multiples can become muddied.

Decode the earnings

The problem comes in on the earnings side of the multiple.

Earnings numbers can differ widely from year to year through the inclusion of, for example, large so-called one-off profits or losses.

That distorts the multiple and can make it misleading, even dangerous.

Accounting standards have tried to clarify that through the introduction of ordinary earnings and headline earnings.

The latter should exclude the one-offs or any other abnormal part of the earnings figure.

But accountants take it further with core earnings, diluted earnings and in a few extreme (ludicrous) cases black empowerment earnings.

Sometimes it’s suspected only the accountant who compiled the results understands what that means, not the CEO or other senior management of the company.

About the best a potential investor can do is to compare ordinary earnings (or EPS) with headline earnings (or HEPS). If the numbers are close, the p:e multiple can probably be used as a reasonable guide.

If the two numbers differ widely, find out why. There may be a reasonable explanation in the commentary accompanying the financial results. If not, beware and use the p:e multiple with care.

Compare

Investors should also remember p:e multiples should be used for relative comparisons:they are not an absolute measure.

So consider if a particular share has a higher or lower p:e against the average for the market (the FTSE/All-share index in this case) or a sub- index, such as the Top 40 index.

For a particular sector, p:e should also be compared between companies in the same sector; cross-sector comparisons can differ widely.

That should offer investors a reasonable idea of whether a share is costly or cheap and, by extension, what the market thinks of the company relative to its share price.

However, if there’s wide divergence between the p:e multiple of one company against its peers in the sector, be wary and find out why.

Most often it will be the result of a “funny” creeping into the earnings number, in which case the multiple becomes pretty meaningless.

Price-to-sales ratio

An alternative is price-to-sales (or turnover): like the p:e, it's the share price divided by a company’s total sales or turnover.

This ratio was popular towards the end of the last millennium but lost credibility when the dotcom bubble burst.

However, it can still be used for comparisons in sectors where sales are important and fairly constant, such as SA’s large food retailers.


 - Finweek
 

equities  |  stock market  |  invest
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