Price/Earnings Ratio

Some of the ratios of balance sheet and profit and loss figures are published as a matter of routine in the financial press - for of course it is the ratios between certain figures in the accounts that are significant for investors, rather than merely the absolute size of such figures. For example, each Saturday the better newspapers quote for each share, as well as the closing market price, the dividend yield (percentage of gross dividend to share price), and also the number of times the dividend actually paid over the last year can be divided into the profits available for that dividend. This ratio is called 'times covered'.

Example

AB Company Ltd has an issued capital of 200,000 ordinary £1 shares. These are priced in the market at 130p. Last year's total after-tax net profit came to £305,000, and a dividend of 7p net per share was paid, 3p as interim and 4p as final. A net dividend of 7p is equivalent to a gross dividend of 10p before tax at 30%.

So yield is:

10

= 7.69%

130

And net earnings per share were:

35,000

= 171/2p

200,000

So dividend was covered 21/2 times 171/2

A high dividend cover indicates large retention of profits and suggests the company may be expanding or poised to expand. Prospects for future rises in dividend and price of shares appear, on the face of things, good. On the other hand, high dividend cover may merely indicate that the fairly recent removal of government restrictions on dividend increase may not yet have worked through. It does not do to make snap judgements without looking behind the figures to the realities.

When total attributable profits are divided by the number of shares in issue one arrives at a figure for earnings per share. If earnings per share are then related to share price one arrives at another useful indicator, the price/earnings ratio (P/E ratio). In the above example, with a share price of 130 and net earnings per share of 171/2p, the P/E ratio was:

7.4

17.5

That means that the share is priced at 7.4 times the annual profits earned per share. The lower the P/E ratio the poorer is the market's assessment of the share as a potential earner of income and growth. Of course, the market may be wrong.


Profit And Loss Account

With the balance sheet there will be a profit and loss account. The accounts of many public companies do not show all the details of how the profit figure is arrived at, but they do show turnover (total sales), and usually the direct operating costs together with all the remaining expenses in total. Net profit before tax is always shown. One can take a view on the ability of the company to continue paying dividends at the current rate, or to increase that rate, by comparing total net after-tax profits available for ordinary shareholders with total dividend. If profits are being retained in the company... see: Profit And Loss Account


Personal And Business Finance 2017

  • You can send us an email if you want to know more about what we do and we will get back to you as soon as we are able.

  • Want to be a published author
    We publish articles on this site if they fulfil our requirments. more>>