Using ratios to analyse companies

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16. Earnings ratios

Definition of earnings: The annual profits of a company after deduction of tax, dividends to preference shareholders, and payments to bondholders. The figure for earnings is in a company's P&L.

The ratios used in connections with earnings are:

• Earnings per share (EPS):
  Earnings / Number of Shares in Issue

  The number of shares in issue can be found in the balance sheet, and it will usually also state the average number of shares in issue during the year.

  For more information on the calculation of earnings, see page 4 of the tutorial 'Interpreting a Set of Reports and Accounts'.

• Price earnings ratio (P/E):
  Current market price of share / EPS

  The P/E tells you how many years you would have to wait to get your money back on your investment.

  Example

  So if shares are trading at £3.00 and the EPS is 60p, the P/E is 5.

  But how meaningful is this? There is an argument that the P/E is a flawed concept because whilst EPS is based on historical data (actual earnings figures) the current market price of a share is based on future expectations. And since future expectations are only partly determined by past performance the logic of a connection between them is tenuous.

  In determining whether a P/E is 'high' or 'low', compare it with the P/E for other companies in the same sector.

• Price earnings growth factor (PEG):
  Prospective P/E divided by the estimated future growth in EPS

  The important thing about the PEG is that both the earnings and the EPS growth are based on brokers' estimates for the next 12 months. i.e. they are comparing like with like. The PEG rule of thumb is that a company with a PEG of less than one is a bargain. But this is a complicated technique, and if it interests you, take the tutorial 'Growth Investing'.

1. Why bother with ratios? 2. A word of warning 3. The P&L and the balance sheet 4. Grouping the ratios 5. Profit margin 6. Return on capital employed (ROCE) 7. Sales as a multiple of capital employed 8. Stockturn 9. Debt collection 10. Payment of trade creditors 11. Cash-to-cash cycle 12. Gearing 13. Interest cover 14. Current ratio 15. Quick ratio (acid test) 16. Earnings ratios 17. Dividend ratios 18. Other ratios 19. Sources of information 20. Conclusion

• Magic Numbers