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There are many aspects and diversified types of income that make up a Companies Revenue, but as an investor you really want to know one thing? What profit the company actually makes, It doesn’t matter if it has massive revenues, If it’s not making a profit, in most instances this would normally make me search elsewhere!
But what exactly is EPS and how is it calculated? Well, it’s a calculation used by taking the net income also known as the bottom line, which is the resulting figure after deducting all the expenses used to run the Company, you know…things like cost of goods, wages, finance expenses, taxes etc, and dividing it by the outstanding shares in the company. Let’s take a closer look –
A Company has 1 million outstanding shares at a price of £1 and has a net profit of £10 million.
The calculations are as follows Companies Net Profit The Outstanding Shares
10,000000 = 10p 1,000000
Ideally we want to look for quality companies that are increasing their EPS year after year, But how do we know if the eps is good or bad? well To make more sense of it, let’s take a look at our next Ratio… price to earnings.
The P/E Ratio developed by the legendary investor Benjamin Graham is a way to measure if the current stock price is undervalued, sound complicated? well don’t worry, as I’m going to break it down and analyse the pros cons. In general the lower the P/E ratio the better, but be warned it could be low for a reason, the Company in question could have run into some trouble or be facing financial difficulties.
An alternative way of looking at it is, if it has a high ratio it could mean the market holds the Company in high regards and expects it to outperform in the future or it could simply be overvalued and come crashing down with a bump. But like anything within the stock market It should only be used as a guide, however it can be incredibly useful when combined with other valuating factors.
lets use this analogy, imagine your buying your favourite car, what would yours be? a Ferrari maybe? from the outside it might look great, but after doing some checks and taking a test drive…you might find out your buying a stinker! If however it’s been well looked after and has low mileage it could well command the asking price.
It’s the same when using the P/E ratio, If all your other requirements and tick boxes fit, it might be the right choice to buy and invest in a genuine bargain or pay the premium for a stock with a higher P/E because it has amazing prospects.
It’s worth having in your arsenal and something I definitely take note of every time I research a potential stock pick, lets take a look at some calculations and examples
The Calculation for the P/E Ratio = share price divided by EPS
If a company has earnings of 10p per share and a P/E ratio of 10 the shares would be priced at £1 With a P/E ratio of 20 the shares would be £2 And with a P/E Ratio of 50 – £5 A couple of examples of low P/E Companies
Cineworld – The second largest chain of cinemas operating in over 10 countries.
At the end of 2022 Cineworld, which was once listed on the ftse 250 had a small P/E ratio of around 3, now on first glance this might make an investor sit up and take notice, but if we do some more research and look under the bonnet we can find out what else might be happening,
Cineworld Revenues in 2019 was already on the decline and then in 2020 the pandemic hit which temporary closed down all operations. Then if you add in the huge debt levels and the effect of streaming sites, it was inevitable it was going to struggle.
It filed for chapter 11 bankruptcy in September 2022 to restructure its debt and eventually delisted from the stock market on 1st August 2023 leaving shareholders with nothing, So a little digging would of discovered exactly what was going on, simultaneously saving you from a loss, or making you a great fortune if you would have shorted the stock!
YU GROUP – A supplier of Utilities to the Corporate Sector
This is one, I have topped up more than once and although the share price has had a massive increase of more than 290% this year alone, it still looks great value! With a P/E of 8 at the time of writing, its in a hot sector, and has net cash which means its debt free and increasing EPS and dividends.
This ticks a lot of my boxes and Unless any problems or question marks appear…definitely one to have in the portfolio.
Lets now take a look at the next ratio
One of the first books I read on the subject of investing was The Zulu Principle, written by the late Jim Slater, although it has been in publication for over 20, I believe it still has relevance in todays markets and after 10 years of ownership its the one book that still sits on my desk to this very day. It is a must read if your intentions are to pick your own stocks.
One of the features in the book was the strength of PEG ratio, the idea is, if you divide the future earnings growth rate into the P/E ratio a peg rating would be established and a rating under 1 would signify a bargain.
Lets first think about what drives up a share price, its generally only 2 components, the first is the growth in earnings and the second is a rerating of the price to earnings ratio. By adding in the PEG, we give ourselves a better chance of picking a potential below value high growth stock. lets take a look at some calculations.
Remember we are looking for a peg of under 1, so lets say a stocks share price is £1 with a p/e of 10 and an estimated growth rate of 5% . 10/5 = PEG of 2 Now a growth rate of 10% 10/10 = PEG of 1 And an attractive growth of 20% 10/20 = PEG of 0.5
As you can see the earnings growth of 20% giving a rating of 0.5 would be more attractive to an investor and might decide they have found a jewel in the crown and that the peg of 2 would signify its over valued. But I will reiterate my previous warning that it should only be used as a guide after taking in other qualifying aspects.
Going back to YU Group which I used as an example in the p/e ratio section and a stock I have in my own portfolio, has a very attractive PEG of just 0.6, and if it can increase earnings as estimated and at a sustainable rate, YU could say, it is a jewel in the crown!
But please remember being a successful trader, is not always about having all the knowledge, its also about how you react to it and adapting to the ups and downs of the stock market, to see more insights and guides please check out some other posts at theleantrader.com.
