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Question: Stock analysts say that the Price to Earnings per share or P/E ratio is the best measure that will tell me if a stock is ripe to buy or sell.
I interpret P/E ratio as the price that investors are willing to pay for the earnings per share of a stock.
What I don’t get is that earnings per share or EPS is not actually paid out to shareholders.
Therefore, why value a stock based on something that is not paid out. Asked at “Ask a Friend, Ask Efren” free service through www.personalfinance.ph, Facebook, and SMS.
Answer: You are right, EPS is not paid out to shareholders. Only cash dividends out of the unrestricted retained earnings of a company are paid out.
Nevertheless, a company’s net income theoretically flows into retained earnings.
By computing EPS, investors are given an idea of how much theoretical earnings each share makes, regardless of whether management will use all or a portion of those earnings for re-investment in the company, the payment of debt principal or the payment of cash dividends.
More importantly, investors focus on the growth of EPS. For if the P/E ratio is to be maintained, the percentage growth in EPS will also require the same percentage growth in the stock’s price.
That growth in the price represents potential capital appreciation and, when sold, realized gain.
It is therefore important to compute for the P/E ratio based on future or expected EPS.
You can either do your own computation or rely on the myriad of projections analysts churn.
Such projections can either be free or for a fee. An example of a free source of information is www.reuters.com. In the search box, just type the trading symbol of the stock you are interested in, add “.ps” and hit “enter”.
You can also get reports from your stock broker.
The depth of the reports is usually commensurate to the amount of trades you do with your stock broker.
Estimating earnings growth is largely a science with a little emotion thrown in.
Being able to buy and sell at the right price is both a science and an art. The reason I say this is because emotions do get in the way when it comes to investing.
And only the professionals have mastered the science and art of investing because that is all they do.
Professional managers also have the size of business to benefit from in depth research, lower transaction fees, and better allocation with (initial) public offerings.
Because they report to their respective Boards of Directors, regulators and shareholders or unitholders, professional managers are also compelled to practice the prudent man rule.
So, if you are the type who just does stock market investing on the side, rest assured that you will enjoy EPS and much more in life if you just leave it to the professionals to manage your money.
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