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In the pinks

In my last two articles, I have started to look at the meaning and uses of information contained in the financial pages of the quality press.

My last article concentrated on information relating to short, medium and long-term expectations on interest rates – a major influence on many aspects of a financial adviser&#39s recommendations, for example, projecting future interest and annuity rates for drawdown and staggered vesting illustrations.

This week, I am returning to the pages containing equity prices to take a closer look at some of the common indicators of a company&#39s financial situation. In particular, I will be applying these principles to the valuation and pricing of investment trusts and some of their deviations.

Most of this information can be divided into that which describes the company&#39s past, current and likely future profitability over a period of time and that which describes the value of the company at a particular time. Such calculations are performed and used by fund managers to identify shares which might be expected to outperform the market in future years although it must be stressed that such calculations are only a part – and not usually the major part – of that decision-making process.

An understanding of this information should, therefore, help a financial adviser understand the behaviour of different equity-based funds. The main items that are of concern are.

Earnings per share.

Dividend cover.

Price/earnings multiples.

Asset value calculations.

Net asset value per share.

To start with the profitability calculations, we can first of all look at a company&#39s earnings per share. I believe an example might illustrate this calculation simpler than a detailed explanation.

The Abacus Construction group has 10 million shares in issue. In the last financial year, the company made a pro-fit of £5m. The company&#39s earnings per share (or eps as it is commonly stated) is the total profitability divided by the number of shares in issue, that is, £5m divided by 10 million, equalling 50p. Thus, for every share in issue the company has made a profit of 50p.

How does the eps figure assist the financial adviser? Besides its uses in the next calculation, it is useful to compare this figure with the dividend per share paid by the company in respect of that year&#39s profits. For example, if the above company paid out a dividend of, say, 45p in the year in which it made earnings per share of 50p, it can be noted that the company has retained little profit in reserves, indicating perhaps that it does not intend to embark on a major capital spending programme.

Although it is highly dangerous – and far too simplistic – to look at one year&#39s calculations in isolation, this comparison should help to indicate that this company&#39s share price might not be expected to grow rapidly over the coming few years as “they pay in dividends most of what they earn”.

By contrast, if the company had paid a dividend of only 5p out of an eps of 50p, it would clearly be retaining profits to fund further expansion or, for example, in the case of drug companies, further costly research. This would indicate a growth share although, I must stress, it is not in itself proof positive of that conclusion.

Frequently, the eps figure is not quoted directly in the share price pages but is alternatively used as part of the dividend cover figure. Where, in our continuing example, a dividend of 45p is paid out of an eps of 50p, the dividend cover is 1.11 (50 divided by 45), whereas the dividend cover would be 10 had the dividend been only 5p. This is simply a more convenient way of illustrating the security of the dividend payment if the company&#39s profitability should fall next year and/or the growth prospects of the share price.

The next calculation I want to look at also relates to the profitability of the company but expresses that profitability in terms of the average profit made by the company during a particular reporting period on behalf of each individual share. Let us continue our earlier example to illustrate this calculation, known as the price/earnings multiple.

The Abacus Construction group has 10 million shares in issue. In the last financial year, the company made a profit of £5m. The company&#39s earnings per share are 50p. The p/e ratio compares this profitability with the current market price of the share. Suppose the current price is, say, £7.50, then the p/e multiple will be 15 (£7.50 divided by 50p).

Put another way, if the company made the same profit every year and paid out all that profit in dividends, the shareholder would receive back the purchase price of his share in 15 years.

Now, it is frequently interesting to ask of people who have just had the p/e ratio explained to them whether they would prefer to invest in a company with a low p/e ratio or a high p/e ratio.

It is tempting for these people to assume that a lower p/e ratio indicates better value within the shares. To illustrate the naivete of this assumption, if a company has a p/e ratio of just one, then the shareholder will be reimbursed for the buying price of the share after just one year of holding that share.

However, life is never that simple and the explanation about the lack of simplicity is crucial to an understanding of the usefulness or otherwise of p/e ratios.

You see, the ratio is calculated using the profit made by the company in the last completed reporting period, which might not be repeated in the next reporting period. A knowledge of the company&#39s current and expected future trading and profitability expectations is essential, as the following example illustrates.

Suppose the share price of the Abacus Construction group was £1 at the time of our above example, when the company&#39s eps – being an historical figure – was stated as 50p. The p/e ratio is only two. However, the share price can be seen to have fallen over recent months as the company has expressed profits warnings which indicate that it may actually fall into loss during the current trading period.

This example illustrates that the market movement in the share – based on knowledge of the fall in profitability which has been indicated in company announcements but has not yet filtered through to the accounts – seems to indicate a far healthier position than is really the case, where the p/e ratio is looked at in isolation.

In reality, a low p/e ratio indicates that the institutional equity investors feel that the company&#39s profitability is likely to suffer in the near future whereas a high p/e ratio indicates that the market expects the company&#39s profitability to rise substantially.

The brief guide in the table below should not be taken too seriously but gives a potted summary of these principles.

In my next article, I will continue this look at these formulae and link these issues with different fund management styles including, as promised above, investment trusts.

Keith Popplewell is managing director of Professional Briefing

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