Investment ratios – 5 of 6 in series on financial ratios

As we have seen in an earlier post the ROCE may be useful to shareholders, but there are a number of other ratios which they may find particularly useful as investors. These are Earnings per Share (EPS) and Price Earnings (PE).

EPS represents the profit per individual share. It as calculated as follows:

EPS:                            Profit after tax, interest and preference dividends

Number of ordinary shares in issue

The top portion of the EPS ratio represents the profit that is available for payout as a dividend. This does not at all mean it will be paid out, but it is the profit available to ordinary shareholders. Given that the bottom portion of the EPS is the number of ordinary shares issued, the EPS is not very comparable between two companies. However, the trend of the EPS of a particular company is an important indicator of how well the company is performing and it is also an important variable in determining a shares price

The PE ratio shows a company’s current share price relative to its current earnings – which assumes the company is a public company and its shares are available for purchases through a stock market. It is calculated as follows:

P/E ratio:                                 Market price per share

Earning per share

It’s usually useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general, or against the company’s own P/E trend. It would not be useful for investors to compare the P/E of a technology company   (typically high P/E) to a utility company (typically low P/E) since each industry has very different growth prospects. Care should be taken with the P/E ratio because the bottom part of the ratio is the EPS, which as stated above may not be that comparable between companies. There are some crude yardsticks for the P/E ratio as follows:

• A P/E of less than 5-10 means that company is viewed as not performing so well;
• A ratio of 10-15 means a company is performing satisfactorily;
• A ratio above 15 means that future prospects for a company are extremely good.

Again, as with all such yardsticks, these will vary by industry and depend on other factors which drive share price e.g. bad publicity, the general economic outlook.

As in previous posts, let’s use the accounts of  Diageo plc from 2010 to calculate these ratios.

EPS = 1,762,ooo/2,754,000   = £0.64 per share (data from p. 107/150)

PE = 1060/64  = 16.6 times (share price from http://www.diageo.com/en-row/investor/shareprice/Pages/Shareprice-History.aspx. Based on the yardstick mentioned above, the PE for Diageo reflects sound future prospects.