Sharemarket basics: a numbers game

Money Magazine, April 2007

Investing in shares can be something of a numbers game, especially when the financial press is peppered with mention of ratios such as "dividend yield" and "earnings per share". There is no shortage of these statistics and they can be useful as a means of assessing whether a particular share offers good returns or strong growth prospects.

On this basis, ratios are worth adding to your armoury of research, though they are by no means infallible. To begin with, ratios use historical data, which is not necessarily a guide for what will happen in the future. And the source data can be open to accounting manipulation, so any insights that ratios provide should be viewed with caution.

Let's take a look at some of the key share market ratios (though this list is by no means exhaustive).

Dividend yield: Calculated by dividing the most recent dividend by the current share price and multiplying by 100 to achieve a percentage figure. Dividend yield is a measure of the regular income return (rather than capital growth) that a share is paying, which allows a comparison between different shares, and also against other asset classes. However, when the share price changes the dividend yield will also change. Indeed, if the share price crashed, the yield would soar, until the next dividend is declared — if there is one.

Earnings per share (EPS): calculated by dividing the net profit of a company by the total number of shares issued. By looking at a company's EPS history, it is possible to see the growth in earnings from one year to the next; and you can compare earnings to the dividend payouts and the share price each year.

Price earnings (PE) ratio: Calculated by dividing the share price by the earnings per share. This often-quoted ratio is a way of measuring investors' expectations about a company's performance, and it is often used to describe whether an individual company, or even the share market as a whole, is "expensive", in the sense that it is overpriced.

Overall share market conditions will have a bearing on the relative PE ratios of different shares but, as a guide, a company with a PE ratio of about 16 is considered to be a growth-orientated company, meaning there's a good chance its earnings will rise. By contrast, a company with a PE ratio of less than 11 may be regarded as having less rosy prospects for earnings growth.

While the PE ratio can be useful for making comparisons between companies, this ratio generally makes more sense if the companies under review operate within the same industry (as average PEs vary between industries), and face the same overall market conditions.

Dividend cover: Calculated as EPS divided by dividend per share. This ratio shows the proportion by which a company's dividend is covered by its earnings. A figure of less than 1.0, for example, suggests the company is paying out more than it is earning. Investors should look for a figure above 1.0, which suggests the company can comfortably pay its dividends.

Net Tangible Assets (NTA): Calculated as the value of shareholders' funds (as reported in the company's balance sheet) divided by the number of issued shares. Also known as the "asset backing", this ratio can give investors an indication of what each share in a company would be worth if all the assets were liquidated and all debts were paid and the remaining proceeds were distributed to ordinary shareholders on a per share basis.

Investors sometimes use the NTA to assess the desirability of a share. If the NTA is greater than the share price, it may be that the company is undervalued — potentially making it a takeover target. Conversely, if the NTA is below the share price, the market may be overvaluing the company.

For the complete story see Money Magazine's April 2007 issue.

http://money.ninemsn.com.au/article.aspx?id=260404

Understanding Earnings per Share and its Impact on Stock Price

Understanding Earnings per Share and its Impact on Stock Price
BY STOCK RESEARCH PRO • MAY 9TH, 2009

A company’s Earnings per Share (EPS) represents the portion of the company’s earnings (after deducting taxes and preferred share dividends) that is distributed to each share of the company’s common stock. The EPS measure gives investors a way to compare stocks in an “apples to apples” way.

The Importance of Earnings per Share in Evaluating Stocks
Fundamental stock evaluation revolves primarily around the earnings a company generates for its shareholders. Earnings, of course, represent what the company makes through its operations over any particular period of time. While smaller, newer companies may have negative earnings as they establish themselves, their stock prices will reflect future earnings expectations. Larger companies are judged mainly on the earnings measure. Decreased earnings for these companies are likely to negatively impact their stock prices.

The Earnings Cycle
Earnings are reported every calendar quarter with the process beginning shortly after the end of a fiscal quarter (a three month period).

Calculating Earnings per Share
The formula for earnings per share can be written as:

(Net Income – Preferred Stock Dividends) / Average Outstanding Shares

Because the number of shares outstanding can fluctuate over the reporting term, a more accurate way to perform the calculation is to use a weighted average number of shares. To simplify the calculation, though, the number used is often the ending number of shares for the period.

Investors can then divide the price per share by the earnings per share to arrive at the price to earnings ratio (P/E Ratio) or “multiple”. This ratio gives us an indication of how much investors are willing to pay for each dollar of earnings for any particular company.

Basic v. Diluted Earnings per Share
In calculating the EPS, one of two methods can be used:
Basic Earnings per Share: Indicates how much of the company’s profit is allocated to each share of stock.
Diluted Earnings per Share: Fully reflects the impact the firm’s dilutive securities (e.g. convertible securities) may have on earnings per share.

Types of Earnings per Share
EPS can be further subdivided into various types, including:
Trailing EPS: Calculated based on numbers from the previous year
Current EPS: Includes numbers from the current year and projections
Forward EPS: Calculated based on projected numbers
Please note that most quoted EPS values are based on trailing numbers.

http://www.stockresearchpro.com/understanding-earnings-per-share-and-its-impact-on-stock-price

Bullbear Stock Investing Notes
http://myinvestingnotes.blogspot.com/

Role of Earnings in Investment decisions

 

Role of Earnings in Investment decisions

 

Once you have got an understanding of Income statement, you are ready to be your own analyst. Each quarter, companies release their earnings, and, for companies using the traditional calendar-year approach, the quarter ended on New Year's Eve. Earnings season is a great time to re-evaluate your current holdings to make sure the companies you own are living up to your expectations. But before earnings are even announced, you might want to review why you made the investment in the first place.

 

Whenever you buy a stock, write down in three or four sentences why you are doing so. State your reasons as objectively as you can. You might want to list such items as

• revenue growth,
• sustainability of earnings or growth over time,
• increased market share,
• increased gross margins,
• price targets for the stock or
• any other reasons you have for making the investment.

For example, you might write, "I am buying XYZ Corp. because I think earnings will grow at a rate of 20% per year and that the price/earnings multiple will increase from its current level of 16 to between 22 and 25."

 

By writing down your assumptions and your goals, you'll create a benchmark that can help you see over time how the company is performing. If you've never done this in the past, you might want to start now.

 

Now take a look at the earnings. The earnings per share (EPS) number is a good place to start. The EPS is the total net profit of the company divided by the number of shares of stock outstanding. But don't just look at the actual EPS and compare it to the expected EPS. Pull out your calculator and crunch some numbers.

 

First of all, has the number of shares outstanding changed significantly?

• Has the company bought back a large chunk of its stock?
• If so, earnings may have improved on a per-share basis, but may have stayed flat or even declined in real terms.

Next, you should be on the lookout for any one-time charges. You will want to remove the effect of the one-time charge, as it only creates noise and makes year-over-year comparisons more difficult.

• Any one-time charge or gain will be stated in per-share amounts as a footnote. Just subtract it from the EPS if it is a gain, or add it back if it is a loss.
• Once you have the EPS number exclusive of one-time items, you can compare it to the EPS from the same quarter last year to see how much growth has occurred.
• Compare the growth figure of your company to others in the same industry.

 

Once you have gotten a good feel for the EPS, it's time to look at the actual numbers on the income statement. Here are some questions to ponder while you have your calculator in hand.

• What does the growth rate in sales look like?
• How was it last quarter?
• Are gross margin percentages better or worse than they have been historically?
• Are expenses increasing faster than sales?

 

Using your written benchmarks for the stock, create a couple of additional questions to help you compare the company's results with your own stated assumptions.

 

 

http://www.karvy.com/buysell/incomestatement.htm

Estimating the Expected EPS & Cash Flow per Share

1. Estimating the Expected EPS

Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.

As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:

20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
202***216
Operating expenses
74***81***Increase by 9.5%
Depreciation
30***34
S&GA expenses
44***47
Operating profit
128***135
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
130***137
Interest
25***24***Decrease by 4%
Profit before tax
105***113
Tax
35***38***Increase by 8.57%
Profit after tax
70***75
Number of equity shares
15 m *** 15 m
EPS
4.67***5.00

Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.

As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.

It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.

2. Estimating the Cash Flow per Share

In addition to the EPS, the cash flow per share which is defined as:

= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares

is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).