Your No.1 tool for beating the City to stock market bargains
What value to put on a share? Given how much stock markets can move prices up and down, it’s a crucial question for private investors like us.
Because if you can spot an under priced business before the big City investors catch on, they will pay you a profit for getting your sums right first.
The vital principle of the P/E ratio
You will have noticed I often refer to a share’s “P/E”. If you’re not sure what this ratio stands for, then believe me when I tell you it’s the single most useful tool for evaluating a share you will ever come across.
And if you already know what “price/earnings” means, then please allow me to give you three new tools to improve your own share analysis and help you pick stronger investments, starting today.
First though, the basics...
P/E stands for “Price/Earnings”. The price is the share price – that bit is simple. The figure for earnings is the amount earned by the company for each individual share over a full financial year.
Suppose a company has issued 2 million shares in total. It makes a profit, after paying tax, of £200,000. That means for each of its 2 million shares, it has made 10p of post-tax earnings per share.
This 10p becomes the “E” of the P/E ratio. And if the share price is £1, then the P/E ratio is 100p/10p = 10.
We can put this another way, and say that the “earnings yield” is 10%. In other words for a share that costs £1, the company delivers a 10p return, which at face value is twice what you’ll get from putting a pound in the bank or building society today.
But here’s where the problems start. We must now ask: “Is the earnings figure accurate?”
Three ways of counting your “E”
Let’s take Christie Group plc as an example. In its financial year to December 2004, it announced “Earnings per Share – Basic” of 20.09p. This was based on a post-tax profit of £4,964,000 divided by 24,708,768 shares (the average number in issue during that financial year).
But Christie also announced “Earnings per Share – Fully Diluted” of 19.79p. And it threw in “Earnings per Share – Basic before Exceptional Items” of 6.04p for good measure! So investors had to work out which of these was most fair. Which P/E should they focus on?
#1. Fully Diluted
Most companies these days have some sort of share option scheme to reward their senior staff. The directors and managers get the chance to buy shares in the company at knock-down prices.
Christie’s books reveal that it is committed to issuing 368,536 new shares to staff at varying prices between 2004 and 2014. Taking them into account would assume that all of the options would be exercised. But directors and managers will dilute your investment if they do take up their options, so you should act as though they will.
In Christie’s case, this increases the number of shares for the ‘Fully Diluted’ calculation to 25,077,304. And that reduces the earnings per share figure by 0.3p.
#2. Exceptional Items
Exceptional items are charges or credits that only happen “once-off”. In the vast majority of cases they are charges. Take another example, William Ransom. Having been on one manufacturing site for 100 years, it has moved to new facilities. Its calculation of earnings per share over the last two years has excluded the £2.115m cost of this transfer. That’s made the “E” in Ransom’s P/E ratio “before exceptional items”.
Christie is an unusual case, however, because its exceptional item in the 2004 figures was a credit. It resulted from early renegotiation of the group’s borrowings for its purchase of Timeless SA back in 2000.
Yes, this looks to be a non-recurring event. But as penny share investors, we must be suspicious. Companies always want to present their earnings per share in the most flattering light. So they may, for instance, treat redundancy costs or legal fees as exceptional items – even though you and I may think they are just part of doing business. Exceptional items might not prove so exceptional.
#3. The Tax Charge
Earnings per share are calculated after charging for corporation tax. The standard rate in this country is 30%. But in 2003, Christie’s tax charge was 55%, and in 2004 it was just 8%. This is very significant, because the lower the tax charge, the higher the earnings per share.
Christie has business throughout Europe, especially in France, and is affected by the different tax rates in those countries. It may also find that losses in one country cannot be offset against profits in another. Lots of other things can affect the tax charge too, such as allowances for capital investment. But with small companies, the most likely cause is their young age.
New businesses typically make losses in the early years. These can be offset against its first profits a few years later. After a while though, those tax losses run out, and the company has to pay the Inland Revenue at the full rate.
So I always assume that a company’s tax charge will tend towards 30% and re-calculate the earnings per share on that basis. For Christie in 2004 that would reduce the pre-exceptional figure from 6.04p to 4.2p.
So the first step in assessing the P/E ratio is to judge whether the reported earnings are fair. The next question is – how much should we pay for these earnings today?
