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Did you know? | How to use EPS and P-E to analyse growth and profitability of a company

Did you know? | How to use EPS and P-E to analyse growth and profitability of a company
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First Published: Wed, Jul 20 2011. 09 39 PM IST
Updated: Wed, Jul 20 2011. 09 39 PM IST
Two of the most widely quoted statistics in relation to a company’s stock performance are the price to earnings multiple (P-E) and the earnings per share (EPS). In general you may think that a higher EPS is better and a higher P-E points to a high-growth company. Just by looking at this data which says: A company has an EPS of Rs 5 per share and a P-E of 15 and B company has an EPS of Rs 8 and a P-E of 10, it is difficult to say which company makes a better investment. Here is why.
EARNINGS PER SHARE
EPS is basically a part of profit allocated to each outstanding share. It is calculated by dividing profit after tax by the total number of common shares issued.
Comparison doesn’t help: The number of shares and the face value of each share can differ from company to company. Additionally, a company can decide to issue fresh shares. All these factors impact the EPS.
For example, company A can have a total shareholder capital of Rs 1,000 with 10 equity shares of Rs 100 each. At the same time, company B can have 100 shares of Rs 10 each with the same shareholder capital. If both companies make a net profit of Rs 50, the EPS of A will be Rs 5 but for B, it will be Rs 0.5.
Look at growth: It is the growth in EPS over a period of time that is important and not the absolute number. EPS growth rate is more important than growth in net profit, especially in a period when additional shares are issued. For example, when there is an acquisition via shares; here profit may grow, but at the same time more shares get issued.
EPS will increase only if the percentage growth in profit is higher than the percentage increase in shares. Therefore, growth in EPS shows the profitability relevant to shareholders of a company.
PRICE-EARNINGS MULTIPLE
This is basically the current price of a company’s stock divided by its EPS. It can be used as a barometer of past performance or as an indicator of future performance. A trailing P-E can be ascertained by using full-year EPS of the previous year and a forward P-E by using the estimates of the current and future year’s EPS.
Context is important: By itself, P-E doesn’t mean much. It has to be looked at in relation to the P-E multiples of similar companies in the industry in terms of size and sector. For example, the P-E of an IT company is typically in the range of 20-30, but that of an auto company is 12-15, owing to the different dynamics of the two sectors. Also, it needs to be compared with the P-E of a market index or the historical P-E of the company itself.
In general, a high forward P-E mulitiple signifies that investors expect the company to deliver higher returns in the future compared with companies with a low P-E. In other words, a company with high growth prospects available at a low P-E, means that there is room for share price rise.
—Lisa Pallavi Barbora
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First Published: Wed, Jul 20 2011. 09 39 PM IST
More Topics: Equities | EPS | Shares | Price Earnings | IT Companies |