Wednesday, 19 June 2013

Price to Earnings Ratio (P/E Ratio)

The price to earnings ratio (P/E ratio) is the ratio of market price per share to earning per share. The P/E ratio is a valuation ratio of a company's current price per share compared to its earnings per share. It is also sometimes known as “earnings multiple” or “price multiple”.

Though Price-earning ratio has several imperfections but it is still the most acceptable method to evaluate prospective investments. It is calculated by dividing “Market Value per Share (P)” to “Earnings per Share (EPS)”. Market value of share can be taken from stock market or online and earning per share figure can be calculated by dividing net annual earnings to total number of shares (Net Annual Earnings/Total number of shares).

P/E ratio is a widely used ratio which helps the investors to decide whether to buy shares of a particular company. It is calculated to estimate the appreciation in the market value of equity shares.

Calculation (formula)
Price to Earnings Ratio = Market Price per Share / Earnings per Share
Price to Earnings Ratio = Market Capitalization / Earnings after Taxes and Preference Dividends

The P/E ratio tells how much the market is willing to pay for a company’s earnings. A higher P/E ratio means that the market is more willing to pay for the earnings of the company. Higher price to earnings ratio indicates that the market has high hopes for the future of the share and therefore it has bid up the price. On the other hand, a lower price to earnings ratio indicates the market does not have much confidence in the future of the share.

The average P/E ratio is normally from 12 to 15 however it depends on market and economic conditions. P/E ratio may also vary among different industries and companies. P/E ratio indicates what amount an investor is paying against every dollar of earnings. A higher P/E ratio indicates that an investor is paying more for each unit of net income. So P/E ratio between 12 to 15 is acceptable.

If  Company A shares are trading at $5/share and most recent EPS is $0.2/share. The P/E ratio will be $5/$0.2 = 25x. This indicates that the investors are paying $25 for every $1 of company’s earnings. Companies with no profit or negative earnings have no P/E ratio and usually written as “N/A”. 

A higher P/E ratio may not always be a positive indicator because a higher P/E ratio may also result from overpricing of the shares. Similarly, a lower P/E ratio may not always be a negative indicator because it may mean that the share has been overlooked by the market i.e. undervalued.  Sometimes,  a low P/E ratio indicates a company is headed over several issues or the company itself has warned a low earnings than expected.  Therefore, P/E ratio should be used cautiously. Investment decisions should not be based solely on the P/E ratio. It is better to use it in conjunction with other ratios and measures. 

The widely discussed problem in P/E ratio is that the denominator i.e. Earnings figure, considers non cash items. Earnings figure can easily be manipulated by playing with non cash items, for example, depreciation or amortization. If it is not manipulated deliberately, earnings figure is still affected by non cash items. That is why a large number of investors are now using “Price/Cash Flow Ratio” which removes non cash items and considers cash items only.

How to Analyze Earnings – varieties of EPS

By definition, EPS is net income divided by the number of shares outstanding, The math may be simple, however, both the numerator and denominator can change depending on how you define "earnings" and "shares outstanding."

There are numerous ways to define earnings, so let's start with shares outstanding.

A . Shares Outstanding
Shares outstanding can be classified as either primary, or basic, (primary EPS) or fully diluted (diluted EPS). Primary EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded.
Diluted EPS entails a complex calculation that determines how many shares would be outstanding if all exercisable warrants, options, etc. were converted into shares at a point in time, generally the end of a quarter. Diluted EPS is preferred, because it is a more conservative number that calculates EPS, as if all possible shares were issued and outstanding. The number of diluted shares can change as share prices fluctuate (as options fall into/out of the money), but generally the Street assumes the number is fixed.
 Companies report both primary and diluted EPS and the focus is generally on diluted EPS, but investors should not assume this is always the case. Sometimes, diluted and primary EPS are the same, because the company does not have any "in-the-money" options, warrants or convertible bonds outstanding. Companies can discuss either, so investors need to be sure which is being used.

B. Earnings
As a general rule, EPS can be whatever the company wants it to be, depending on assumptions and accounting policies. Corporate spin doctors focus media attention on the number the company wants in the news, which may or may not be the EPS reported in documents filed with the Securities Commission (SC). Based on a set of assumptions, a company can report a high EPS, which reduces the P/E multiple and makes the stock look undervalued. The EPS reported, however, can result in a much lower EPS and an overvalued stock on a P/E basis. This is why it is critical for investors to read carefully and know what type of earnings is being used in the EPS calculation.

While the math may be simple, there are many varieties of EPS being used these days and investors must understand what each one represents, if they're to make informed investment decisions. For example, the EPS announced by a company may differ significantly from what is reported in the financial statements and in the headlines. As a result, a stock may appear over or under-valued depending on the EPS being used. This article will define some of the varieties of EPS and discuss their pros and cons.

There are five (5) types of EPS to be defined in the context of the type of "earnings" being used:

Reported EPS (or GAAP EPS)
We define reported EPS as the number derived from generally accepted accounting principles (GAAP), which are reported in SC filings. The company derives these earnings according to the accounting guidelines used. A company's reported earnings can be distorted by GAAP. For example, a one-time gain from the sale of machinery or a subsidiary could be considered as operating income under GAAP and cause EPS to spike. Also, a company could classify a large lump of normal operating expenses as an "unusual charge," which can boost EPS because the "unusual charge" is excluded from calculations. Investors need to read the footnotes in order to decide what factors should be included in "normal" earnings and make adjustments in their own calculations. (To learn more about what can be found in the footnotes). 

Ongoing EPS
Ongoing EPS is calculated based upon normalized, or ongoing, net income and excludes anything that is an unusual one-time event. The goal is to find the stream of earnings from core operations, which can be used to forecast future EPS. This can mean excluding a large one-time gain from the sale of equipment, as well as an unusual expense. Attempts to determine an EPS using this methodology is also called "pro forma" EPS.

Pro Forma EPS
The words "pro forma" indicate that assumptions were used to derive whatever number is being discussed. Different from reported EPS, pro forma EPS generally excludes some expenses or income that were used in calculating reported earnings. For example, if a company sells a large division, it could, in reporting historical results, exclude the expenses and revenues associated with that unit. This allows for more of an "apples-to-apples" comparison.

Another example of pro forma is a company choosing to exclude some expenses, because management feels that the expenses are non-recurring and distort the company's "true" earnings. Non-recurring expenses, however, seem to appear with increasing regularity these days. This raises questions as to whether management knows what it's doing, or is trying to build a "rainy day fund" to smooth EPS.

Headline EPS
The headline EPS is the EPS number that is highlighted in the company's press release and picked up in the media. Sometimes it is the pro forma number, but it could also be an EPS number that has been calculated by the analyst or pundit that is discussing the company. Generally, sound bites do not provide enough information to determine which EPS number is being used. (For more on how companies can skew their results, read 5 Tricks Companies Use During Earnings Season.)

Cash EPS
Cash EPS is operating cash flow (not EBITDA) divided by diluted shares outstanding. Generally, cash EPS is more important than other EPS numbers, because it is a "purer" number. Cash EPS is better because operating cash flow cannot be manipulated as easily as net income and represents real cash earned, calculated by including changes in key asset categories, such as receivables and inventories. For example, a company with reported EPS of 50 cents and cash EPS of $1 is preferable to a firm with reported EPS of $1 and cash EPS of 50 cents. Although there are many factors to consider in evaluating these two hypothetical stocks, the company with cash is generally in better financial shape.

Other EPS numbers have overshadowed cash EPS, but we expect it to get more attention because of the new GAAP rule (SFAS 142), which allows companies to stop amortizing goodwill. This version of "cash EPS" is more like EBITDA per share and does not factor in changes in receivables and inventory. Consequently, it may not be as good as operating-cash-flow EPS, but is better in certain cases than other forms of EPS.

D. Conclusion

There are many types of EPS being used and investors need to know what the EPS numbers they see represent and determine whether they are a good representation of a company's earnings. A stock may look like a great value because it has a low P/E, but that ratio may be based on assumptions which, upon further research, you might not agree with.

Monday, 17 June 2013

Financial Reporting  & Analysis

Audit Opinion / Qualification

What is an audit opinion?
An audit opinion is expressed on audited statements. It is required that an auditor state in the opinion that generally accepted accounting principles have been followed that they have been applied on a basis consistent with that used the preceding year.

Types of Audit Opinions
Unqualified opinion — The unqualified opinion has no reservations concerning the financial statements. This is also known as a clean opinion meaning that the financial statements appear to be presented fairly.

Qualified opinion / “Except for” — This means that the auditor has taken exception to certain current-period accounting applications or is unable to establish the potential outcome of a material uncertainty as a going concern.

Disclaimer opinion — This is a special type of audit report that should be issued when the auditor permits his or her name to be associated with financial statements that were not examined in accordance with generally accepted auditing standards. Sometime due to  inablility to express opinion or  pervasive uncertainty.

Adverse opinion — This is a type of audit opinion which states that the financial statements have material effect on fair presentation of  the financial position, results of operations, and changes in financial position, in conformity with generally accepted accounting principles.