Numbers game

In the latest in our series on how to understand the markets, John Andrew examines the price-earnings ratio

If you look at the market report/shares page in The Independent you will see that the penultimate column for share prices is headed P/E. This is an abbreviation for "Price-earnings ratio". This term, as Stuart Valentine of ProShare says: "is widely quoted, but little understood.

"It is often used as a yardstick to measure how `expensive' a share is: the higher the P/E, the more expensive the share as a rule." A P/E ratio tells you how many years it would take for the net profit after tax to equal the current share price. It may be also be viewed as the City's confidence ratio. Generally, the higher the P/E, the higher the market's regard for the company.

The P/E ratio is a simple concept. It is calculated by dividing the company's current share price by earnings per share. This may be over a complete financial year, or on an interim-to-interim basis.

A high P/E could indicate that the company's performance is bounding ahead of its most recently published earnings. In other words, investors are expecting increased profits on results day and consequently the shares are in demand. Only time will reveal whether this is a correct judgement.

On the other hand, a company which is doing badly may have a high P/E. This reflects the view that it may be the subject of a takeover bid, increasing its share price.

Earnings per share must not be confused with dividends. The latter is the income distributed to shareholders. On the other hand, earnings per share generally refers to the net profit after the preference dividend has been deducted. Not all of a company's distributable profits are paid to shareholders by way of dividend. A proportion of the profits is retained within the business for expansion. The retained profit will, hopefully, be reflected in the share price as the value of the company increases.

Glancing down the P/E column in our share price page, you will notice that there are one or two gaps. This is because in these cases, such factors as taxation, income distribution or objectives, makes the ratio meaningless or irrelevant.

The P/E ratio for a particular company can differ from one publication to another. For example, the ratio given in The Independent may be different from that found in a stockbroker's newsletter. On occasions the difference is significant and cannot be explained by "rounding", or the fact that the calculations were made on a different day. The reason for the difference is that although the concept of the ratio is simple, one of the factors in its calculation is complex.

The current share price is a matter of fact. It is in what constitutes "earnings per share" that differences arise. There are three basic ways of defining earnings: the nil, the net and the maximum methods. An explanation of the three methods, which centre on how the payment of dividends affects a company's mainstream tax, is complex and it is sufficient for our purposes to say that each one produces a different result.

There is another reason, linked to developments in UK fiscal law, as to why differences in the P/E calculations can differ. Also, sometimes a prospective P/E ratio is given in stockbrokers' newsletters or financial comment in the press. This simply means that an estimate of the company's future earnings per share has been used, as opposed to historic earnings.

Sometimes you will see a reference to a particular P/E ratio being "undemanding". This means that the ratio is low compared to similar companies. In other words the company's growth potential is not considered to be high. As it is easier for a company to miss high growth expectations than ones which are low, the P/E is said to be undemanding.

Remember that if a company has a high P/E ratio, it is no guarantee that the future will live up to expectations. The market's confidence may be completely misplaced. The P/E is only one of the yardsticks that professionals use