09 June 2014

PE Ratio - Good Indicator for Shares Investment?

One of the indicators that I would put it into my stock screening is PE ratio, which is Price / Earnings Per Share ratio. Why this is my preference?

If you look at PE ratio, there are two key elements: Share Price and EPS. As long as we could purchase the shares at lower price tag, the better potential return we could get in later years. But now, we have to be very careful on determining EPS as EPS is not as simple as you thought.

EPS is derived from net earnings divided by average outstanding shares and both are calculated using accounting standards that could be manipulated by the company. First of all, if there is any corporate action during the financial year, for example bonus shares or private placement / warrant exercises etc, the average outstanding shares could be misled as it is always under estimated by using average method. So, I would use number of outstanding shares at the end of financial reporting period instead.

Secondly, there are many items in between top line and bottom line of income statements. We should exclude all the non-recurring items in calculating underlying net earnings, for example gain from disposal of subsidiaries / investment etc.

There are also other incomes that would make up a big stake in bottom line of income statements, such as fair value gain of investment properties (from property developers) / biological assets (from plantation players) / derivatives gain (etc. hedging from hedging currency risks normally implemented by multi-national companies) etc. We need to make our own judgement so that those income could be normalized or re-calculated using more conservative method.

FRS115 method also allows the net earnings of property developers fluctuate, as earnings and revenue of industrial / commercial projects / Executive Condominiums could only be recognized upon TOP. This also may lead to volatility of future earning power of the company as well as the share price.

So, in summary, we may also need to do our own calculation before deriving the underlying net earnings and EPS so that we could have better picture of the PE ratio (as well as future PE ratio) as we are investing in long run.


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