COMMERCIAL How To Understand The Price-Earnings Ratio

Press, Volume CV, Issue 31032, 12 April 1966, Page 19

COMMERCIAL How To Understand The Price-Earnings Ratio

fßy C. R. HASSELDINE, Lecturer in Accountancy, University of Canterbury.]

Recently the term price-earnings ratio is being used more frequently in the financial literature of this country, but there is evidently still some uncertainty about its nature and utility.

One early New Zealand article described the ratio as “the perfect yard-stick for comparing company share values,” while the latest edition of a popular guide to investors says that it may be regarded as “the universal figure for comparison of share prices of unlike companies sometimes looked upon as a confidence yield. . . The higher the p/e ratio the greater the confidence in the share.”

An examination of the true nature of the price-earnings ratio and of the factors causing it to vary, both over time and between companies should restore at least a modicum of scepticism to those who may have taken these claims at face value. In the evaluation of the relative worth of shares one should be careful not to rely on a single measure. This holds true for the P.E. ratio. Nature Of The Ratio It may be understood best by relating it to another more familiar financial ratio—the earnings yield. Earnings yield may be defined as current (or more properly past) earnings per share expressed as a percentage of current share price. For example the earnings price ratio of the N.Z. Farmers’ Co-

op. Assn, of Canterbury, would be:— Tax paid earnings year to July 31 £156,372 Number of shares 4.000.000 Earnings per share approx. 9.6 d Price per share (April 1) .. 8/1 Earnings yield .. 9.6d=T0% 8/1 The price-earnings ratio is calculated by the inversion of tins fraction and hence is the reciprocal of the earnings yield. In the case quoted, the ratio is 10. A more precise definition of the P/E. ratio would be “The price the investor is willing to pay for a unit of current earnings.” Even this definition is not quite satisfactory as the earnings used in determining the ratio are those of a past period—the one most recently reported.

Points to note in considering the ratio are: —

(I) There are three determinants to the ratio —reported earnings, number of shares and quoted price. (H) Earnings must be adjusted where appropriate to provide for preference dividend requirements. (III) Earnings are those of the most recently reported period and are net after tax. (IV) Like dividend yield it provides a common measure regardless of the par value or even the paid up value of the shares. Changes in the Ratio Like other financial measures, the ratio will change over time if the three determinants are themselves changed. These changes will usually be of two kinds (a) Continuous changes—usually of a small magnitude. (b) Infrequent but sometimes quite significant movements. Market Appraisal The ratio will be affected by the normal operation of the share market as prices of shares in general, and those of industry groups and individual companies, change in response to the various forces which determine share price levels. Normally these changes will give rise to small movements in the ratio but fairly substantial shifts are possible if the prices of particular shares are influenced by factors such as electoral results, particular legislation, strikes and their settlement, discovery of new resources, etc. Changes in reported income These changes produce two effects. They involve a recalculation

of earnings per share and at the same time involve a reassessment of the worth of the share and hence affect the price also. It is difficult to predict how this two-fold effect will resolve the P/E ratio for any particular share either in the direction of the change or in the magnitude. The direction of the change will depend inter alia, on whether the newly reported income was in line with market expectations and whether the trend of earnings is thought likely to continue or be reversed.

If earnings tend to fluctuate (e.g. as in the freezing industry) substantial changes in either direction are likely to occur in the ratio at the time of release of the accounting reports.

Naturally these major recalculations are not spaced at exactly yearly intervals—the time interval depends on the speed with which reports are presented after two successive balance dates.

Changes in Subscribed Capital There are two aspects to this factor in considering the P/E ratio.

(1) Effects on price. (2) The recognition problem —by which is meant—when can one take the additional shares into account in recalculating earnings per share?

Both aspects can be considered in the several situations which are likely to arise. Raising Capital by an Issue of Shares

The last reported income will not have changed but the number of shares has, so that immediate recognition of additional shares depresses earnings per share and, given no change in price, would increase the ratio. If after a time lag the increased capital results in additional reported income, earnings per share would, other things being equal, rise again and the ratio then falls. The possibilites are: (a) Continue to use the former number of shares, i.e., do not alter earnings per share until the next income statement is available and then recalculate. This was done in the example of N.Z. Farmers which issued additional shares subsequent to its 1965 balance date. (b) Immediately recalculate earnings per share recognising the increased number of shares. (c) Recalculate when the additional capital has been employed for a full year or is fully productive—if this can be determined.

Issues of new shares do of course also have an effect on price depending on the terms of issue, the markets assessment of the profit earning capacity of the additional funds and on expected changes in dividends. None of these solutions are entirely satisfactory—but they remind one that measurement of earnings per share is not free from problems. Consider the problem in the

case of the New Zealand Refrigerating Company. This company has two classes of equity capital—one of which does not participate in dividends until 1968. How does one define earnings per share in this situation? It is possible in fact to work out two price earnings ratios—which would then be the confidence yield? Bonus Shares

This type of issue does not give rise to the same problems since there is usually an immediate effect on price and simultaneous recalculation of earnings per share is desirable.

However, changes in price are not always proportionate to the terms of the issue so that the ratio itself may well move substantially when the issue is announced.

The ratio may also move if prices reflect the anticipation of a bonus issue.

Reorganisations. Mergers and Acquisition by Exchange of Shares

Changes of capital falling in this category can present rather awkward problems in the calculation of price earnings ratios.

These problems cannot be discussed in detail but mainly arise from the difficulty in defining earnings per share, particularly where the merging companies had different balance dates or both did not make profits in their latest years.

Convertible Notes The use of this source of funds also gives rise to difficulties of measurement and recognition. Here the conditions are generally the reverse of those where capital is raised by an issue of shares, since reported income will normally have been influenced before the additional shares can be recognised and earnings per share recalculated.

The conversion operation itself will affect future income insofar as the contractual liability for interest charges disappears. Dividend Declarations These affect the ratio in two ways. Small changes in price may occur depending on the proximity or otherwise of the next interim and final dividends. Furthermore changes in dividends also affect price, and hence the ratio, although this latter effect is more likely to be associated with the recalculation of earnings per share made after publication of the annual accounting reports. So far the, definitional and measurement problems have been considered together with the main factors causing the ratio of a particular company to vary over a period of time. Part II of this article will be concerned with the difficulties inherent in attempts to use the ratio for comparing the worth of shares of groups of two or more companies. (To Be Concluded) Winstone Interim.— Winsitones, Auckdand-based manufacturer of concrete masonry, ready-mixed concrete and building board, and builders'’ merchant, will pay a steady 2i per cent interim ordinary dividend on April 28 on shares issued before November 30 last; ex dividend April 15. Laisit year’* total was 7J per cent.