11 Sep 2013

Equity Valuation Metrics

The P/E ratio (Price-to-Earnings ratio) of a stock (also called its “earnings multiple”, or simply “multiple”) is a measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios.

The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12-month period, divided by number of shares outstanding.

For example, if Stock A is trading at $30 and the earnings per share for the most recent 12-month period is $3, then Stock A has a P/E ratio of 30/3 or 10. Put another way, the purchaser of Stock A
is paying $10 for every dollar of earnings. Companies with losses or no profit have an undefined P/E ratio. However, a negative P/E ratio may be shown.

By comparing price and earnings per share for a company, one can analyse the market’s stock valuation of a company and its shares relative to the income the company is actually generating. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal, it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies and time periods may be misleading. Hence, more complicated peer group analysis is required.

Care should be taken when analysing P/E ratios. It is also common market practice to use historic P/E ratios, or forward P/E ratios which factor in future consensus corporate growth rates. Either way, how do we interpret in a simple manner what the ratios means? If a company trades on a P/E ratio of 10, we could conclude that it takes about ten years to recoup the price paid for a stock (not including any income from the reinvestment of dividends). In principle, the P/E ratio incorporates the market’s view of future growth prospects and perceived riskiness of a company’s future earnings.

Various interpretations are possible, but the table below gives an indicative guide as to their meaning:

The dividend yield is the dividend paid in the last accounting year divided by the current share price. If a stock paid out $5 per share in cash dividends to its shareholders last year, and its price is currently $50, then it has a dividend yield of 10%.

The earnings yield is the reverse/reciprocal of the P/E ratio. The earnings yield is quoted as a percentage, and is useful in comparing a stock, sector, or the market’s valuation relative to bonds. The earnings yield is also the cost to a publicly traded company of raising capital through the issuance of stock.

No comments:

Post a comment