What is PE and EPS Ratio?

The EPS is profits (after tax and everything else) divided by the number of shares in issue. It is the amount of the company’s profits that belong to a single ordinary share. Companies are required to publish the statutory (also called “basic”) EPS but there are a number of adjusted EPS numbers which can be more useful to analysts.

Headline EPS
It is common to use the headline or adjusted EPS rather than the statutory EPS. The usual adjustment is adding back goodwill amortisation and exceptional costs to profits. Amortisation is excluded because it is non-cash and has no impact on future cash flows. Exceptional items are excluded because they are intrinsically one-off items and distort underlying trends - and therefore again do not help investors estimate future cashflows.

Companies often disclose the headline EPS and analysts forecasts are usually of the headline EPS as well. However the exact definition varies and different companies and analysts use different adjustments.

The IIMR (Institute of Investment Management and Research) has set out a widely used definition of headline EPS which excludes certain items (of an exceptional nature) which are excluded regardless of whether the company concerned has classified them as exceptionals or not, thus allowing fair comparisons of companies which may have different approaches to classifying expenses as exceptional or not.

Diluted EPS
The statutory EPS is calculated using the weighted average number of shares in issue during the period. A diluted EPS is calculated using all shares in issue and those due to be issued (e.g. under share option schemes). A fully diluted EPS is calculated using all shares issued, due to be issued and which could be issued if all existing options are exercised, convertible bonds are converted to equity etc.

When we use the term EPS without qualification we usually mean headline/adjusted EPS, diluted where it is practicable or particularly relevant.

PE Ratio
The price/earnings ratio, usually abbreviated to PE, is the most commonly used valuations measure. It compares the price of a share to the company’s earnings (net profit) per share. It directly relates the price of a share to the proportion of the company’s profits that belong to the owner of that share.

One of the reasons for the popularity of the PE ratio is its simplicity. It can be calculated simply by dividing the share price by the earnings per share (EPS). It is common to use the headline or adjusted EPS rather than the basic EPS.

The other common adjustment is the use of a diluted EPS, which is the share of profits of each share taking into account shares that are expected to be issued - for example as a result of share options or the conversion of convertible bonds.

A higher PE means that the same share of a company’s profits will cost a prospective shareholder more. There are usually reasons for a higher PE, which may reflect faster expected earnings growth, or lower risk earnings.
Prospective PE vs Historical PE
As investors are primarily interested a company’s future profits it is common to calculate the PE based on forecast earnings. To distinguish between these the PE calculated using the previous financial year’s earnings is called the historical PE, and that using the current financial year’s forecast earnings the prospective PE. Both of these and PEs based on another year’s earnings may be referred to by giving the year the earnings of which (actual or forecast) are used.

Trailling PE
The trailing twelve months PE is the PE for the most recent 12 months for which results are available rather than the last full year for which results are available. For example if a company reports half yearly the trailing 12 months PE would be the calculated by adding the PEs of the two most recent half years for which results are announced. If a company reports quarterly it would be the sum of the four most recent quarters. It shares with the historical PE the advantage of being a certain number rather than the forecast, but it is more up to date than the historical PE.

Relative PE
PE comparisons are more meaningful if they are made between similar companies. They are very often used to compare companies in the same sector, which are presumed to have similar long term growth prospects.

Taking this further the PE can be divided by the average PE for the companies the comparison is being made with. Most often a company PE is divided by the PE of its sector, or of the market as a whole to show how expensive the company is in comparison. Market and sector PEs are calculated as:

Total market capitalisation ÷ total net profits

Using PE
A lower PE does not necessarily mean a share is a better buy than another with a higher PE. Investors need to ask what justifies paying more for the more expensive (higher PE) company - does it have better growth? is it lower risk?
Although PE is the most widely used valuation ratio and has the advantage of being comparatively simple it is not the only valuation ratio and investors should use other as well. Its close relative the PEG ratio provides a crude adjustment for growth, while EV/EBITDA is distorted by financial structure (how indebted, or not, a company is) while PE is. Discounted cashflows are theoretically the most correct form of valuation but are harder to do.