7.2 Market Ratios
PE Ratio = Market Price per share ÷ Earnings per share
Note: Earnings per share (“EPS”) = Net Income divided by the number of shares the company has (“Number of shares outstanding”). For example, if a company earned $1 million and has 500,000 shares outstanding, its EPS is $2 per share.
This, rather than the dollar price, may be used as a measure of “cheapness” or “expensiveness” of a stock. “Value” stocks are generally characterized by low PE ratios. A Value Stock may be thought of as such because its price – relative to its earnings – represents a “good buy” for the money, i.e., cheaper. The analyst must be cognizant of the possibility that a low PE may also mean that its future earnings prospects are generally deemed unfavorable.
In contrast, Growth Stocks will reflect (very) high PEs on the basis of generally optimistic views of future earnings growth. Does this mean that earnings will necessarily catch up with price? Let’s say that a company’s PE = $50/$1 = 50 times earnings. That is a very high ratio. If the market anticipates next year’s earnings to double, the stock may be said to be trading at just $50/$2 = 25 times next year’s earnings, a more reasonable ratio.
High PEs are the effect of the high expectations the market has for future growth in a company’s earnings. As a company’s earnings grow in the future, the multiple that one paid for his shares goes down, making the purchase, with the benefit of hindsight, a good choice.
For example, if a company earns $1 per share and sells for $50, its PE will equal 50x earnings, quite high, quite “expensive” for what you get. If, however, the earnings next year do indeed grow to say, $5 per share, the buyer at last year’s price who purchased the stock for a meager $50, or only 10x next year’s earnings, got a good deal. Therefore, companies with high growth expectations will manifest higher PE ratios than the boring companies with low growth prospects. A stock analyst might have said that the PE ratio is now 50x, but only 10x next year’s expected earnings – if s/he so prophesied.
At the time this is being written, average PE ratios for the S& P 500 Index of (publicly-traded) stocks are approximately “20 times earnings.” Why would someone pay so much for each dollar of earnings? In contrast, privately-owned stocks, i.e., those not traded on the public-markets, will have much lower PE ratios.
One explanation has to do with the Liquidity Premium associated with publicly traded stocks. “Liquidity” has to do with the ease and speed with which a seller can convert an asset, in this case stock, into cash while obtaining a sales price that represents that asset’s true value, i.e., without reduction in price from its true, or “intrinsic” value.
It is generally very easy to buy and sell a stock. All one needs to do is place an order with a stockbroker (and pay for it within the required three-day settlement period for stock). There is an added or premium value in this liquidity. That is why “Private Equity” investments can be so profitable. A private company will sell at a much lower PE ratio due to the lack of liquidity. If the company is later sold in an IPO (“initial public offering” – the point at which time a stock is sold to the public for the first time), there will be much profit to go around!
The true cost of buying a privately owned company, i.e., one whose stock or equity is not traded on the public stock exchanges, is not embedded in the price one pays for buying such private corporations. In order to purchase a privately owned company, one has to search for an appropriate one, one that is also available to purchase. This involved time and time is money. The potential buyer is spending time engaged in the search rather than pursuing other profitable opportunities. This is not an issue where publicly traded stock is concerned. These companies are readily available for rapid purchase and sale.
Moreover, in order to buy a private company, one must employ the services of an attorney to negotiate and close the deal. Bankers must be involved because private stock is usually purchased with large (and often borrowed) sums as opposed to the purchase of a minimum number of shares of stock in a publicly traded stock corporation with few funds. These other costs must be reflected as opportunity costs and thus, under the “Law of One Price” ought to be reflected in the prices of publicly traded stock. Law of One Price requires that similar assets ought to be priced similarly.
There are certain demerits to the PE Ratio. For instance, Earnings are subject to accrual accounting manipulations. Moreover, companies with very low or negative earnings yield a meaningless PE ratio. A company with low earnings may command a ridiculously high PE. A company with negative earnings will not yield a PE at all – it is not computable!
Dividend Yield = Dper share ÷ Pper share
One may view this as the Cash-on-cash Return that a stock may provide. If I pay $10 for Yawr Co. stock and it pays an annual dividend of $1, my “cash-on-cash return” or dividend yield is 10%. Some industries will reflect higher dividend yields than others. Dividends are usually paid from current net income, but if there are losses, dividends would have to be paid from retained earnings. Typically, mature, rather than growth companies, pay high dividends. This yield ignores price changes.
It is eminently noteworthy that the dividend yield excludes any capital growth, which is integral to Yawr Co. stock’s Total Return. In other words, the Total Return equals the dividend yield plus the capital gain (or loss) expressed in percentage terms. If you purchased this stock for $10 and sold it at $15, your capital gain would be 50%. The Total Return is: 10% + 50% = 60%.
It is often considered a positive Signal that a company maintains its dividend in the face of losses. This Signaling indicates management’s optimism about future earnings prospects. The dividend itself thus boils down to a “human decision” by the firm’s board of directors, rather than a measure of business performance per se. If the board feels that the future is good, it may choose to pay dividends even if the company is presently losing money.
Dividend Payout Ratio = PR = DTotal ÷ NI = DPS ÷ EPS
This ratio indicates the percentage of net income, which is paid out to common shareholders as dividends. If a firm earns $1,000,000 and pays $100,000 in dividends, its payout ratio is 10%. If there is preferred stock, the preferred dividends would first have to be deducted from the net income. The PR formula would be adjusted: PR = (Common Stock Dividends) ÷ (Net Income – Preferred Stock Dividends).
Retention Rate = RR = 1 – PR = (NI – DTotal ) ÷ NI = ARE ÷ NI
This ratio indicates how much of the company’s earnings are retained internally for future growth and, as such, together with the firm’s ROE impact the firm’s growth potential. On the next page, we discuss the relationship between earnings retention and firm’s growth. (This will be explicated further below in the “EFN Model.”) Naturally, PR + RR = 1.0 = 100%.