Investing in stocks- Part 4

Today I want to look at two ratios that you are sure to encounter when dealing with stocks.  For the purposes of both ratios we shall use the following information:

                                                2009                2008                2007

Net profit(000’s)           1,200               1,000                  800

Share capital(000’s)                 1,000               1,000               1,000

Market price                            $12.00             $7.00               $9.00              

 The first is called earnings per share (EPS) and is calculated by dividing the net profit after tax by the number of shares in issue.  It must be noted that it is the number of ordinary shares that are used and that preference shares do not form part of the computation.  There is one company in Jamaica that calculates using preference shares (Jamaica Livestock Association) but that is an exception to the rule.  For our example the calculation of earnings per share will yield

                                                2009                2008                2007

                                                $1.20               $1.00               $0.80

This ratio gives you the return that each ordinary share makes to the profit of the company. Generally speaking, the higher the return then the better the company is doing.  In our case, earnings per share have been increasing each year and this implies that the company is growing. 

One of the weaknesses in using this ratio is that it does not take into account inflation or changes in the exchange rate.  This ratio can also be used as a guide to the amount of dividend to expect as the more a company makes the higher the level of dividend may be.

 The second ratio is closely connected with the one above is called the Price/Earnings ratio or P/E ratio as it is more commonly called.  It is calculated by dividing the market price of a share by its earnings per share.  In our case this will result in

                                                2009                2008                2007

Price/Earnings ratio      10.00               7.00                 11.25

This ratio measures the relationship of the market to a company’s earning and is one of the ways of valuing a company.  For example if a company is to list for the first time and has an EPS of 50 cents and similar companies trade at an average P/E of 10 then we would value the stock at $0.50 times 10 which is equal to $5.00.  In our example you will notice that the P/E ratio is not constant, this is because the ratio is affected by the state of the economy.  In good times the P/E ratio tends to increase whereas in recessionary times the ratio declines.  In other words this ratio can also be used to measure the confidence that investors have in the economy.

 I must stress that the calculations for EPS are very basic and that in reality there can be other factors affecting the number of shares to be used in the computation.  My role as always is to introduce one to the concepts and if you wish to get more information on the topic there are many financial accounting textbooks available that deal more adequately with the subject.

Tags: Carl Wilson