Investors shouldn't take a company's P/E at its face value.
A company's price-earnings ratio (P/E) is the fundamental statement of how the market rates its shares. Profit is divided between the number of shares on issue to give earnings-per-share. The EPS is then divided into the latest published price, thus indicating the cost of the share relative to the earnings attributable to it. The arithmetic is simple enough, so what grounds for confusion could there be?
As it happens there are plenty. While the P side of the formula is straightforward enough - you can look up the share price in the paper any day - the E is less so. For a start, the profit used in the calculation of earnings may be based on a possibly inaccurate forecast (to give a 'prospective' P/E), or it may be an actual sum recently declared and published by the company, ie 'historic'. The results can be very different. But even an historic P/E may be a far less solid figure than it seems. The profit used is invariably after-tax, and after interest charges, minority interests in the company and any preference share dividends. But tax is far from simple. In the UK, Advance Corporation Tax (ACT) is payable on dividends as a kind of pre-payment for Corporation Tax. Some earnings models account for any ACT which can't be recovered. Some don't.
At one time the 'bottom line' earnings appearing in a company's published report and accounts left out one-off items which were not part of its normal trading and could not be expected to recur: profits (or losses) on disposal of assets or subsidiaries, major disasters, and so on. These days virtually everything has to go above the line. The result is more disclosure, but at the cost of greater volatility in the earnings measure.
When the changes came into effect at the end of 1992, brokers Hoare Govett predicted a 'descent into chaos', with myriad different EPS figures for each quoted company. In practice, the market took the new regime in its stride, thanks partly to the analysts' professional body, the Institute of Investment Management and Research, which devised a formula for 'headline earnings'. This includes all trading profits/losses, and earnings for businesses which the company has acquired or disposed of during the year.
Items such as profits/losses on the sale of fixed assets or businesses, write-offs of assets and so on, are omitted. The formula still doesn't fit everyone: 'A core part of our business is selling off old paint, but the consistent profits we make from this are excluded from headline earnings under IIMR guidelines,' complains the finance director of a big hire company.
Nevertheless, as IIMR secretary-general Tony Newman says, it is the market's benchmark. 'It is quoted by both Footsie and Extel.' Patrick Yau of private client brokers Killik & Co agrees that simplicity is important: 'You have to be pragmatic. Clients want comparability, and private clients have different needs from those of fund managers. If I put out a client note with three EPS figures, that would just confuse the client.'
For brokers dealing with the big institutions, however, their analysts' techniques for interpreting company accounts represent a competitive advantage. This makes them reluctant to talk about details. And there may be special reasons for their sensitivity. As one analyst says: 'Many of the companies whose figures are being adjusted are also our clients. We are trying to unmassage their figures.'
Clearly, for the individual investor, comparability is usually the most important issue, yet even today there is no complete comparability. Another example: figures from different sources may be calculated on different bases. Someone looking for 'maintainable' earnings, may also find it worth stripping out - as many brokers' analysts do - earnings for businesses disposed of during the period. Certainly it shouldn't be assumed that a P/E can be taken at face value.