Price earning Ratio

Perhaps the most popular financial statistic in stock market discussion, the price earnings ratio is defined as:

Market price per share / Earnings per share

The market price per share may be the price prevailing on a certain day or the average price over a period of time. The earnings per share is simply profit after tax less preference dividend divided by the number of outstanding equity shares.

Take a case a Company whose price earnings ratio at the end of 20X1 is: 21.0 / 2.27 = 9.25

The price earnings ratio (or the price earnings multiple as it is commonly referred to) is a summary measure which primarily reflects the following factors: growth prospects, risk characteristics, shareholder orientation, corporate image, and degree of liquidity.

Yield: This is a measure of the rate of return earned by shareholders. It is defined as:

Dividend + Price change / Initial price

This may be split two parts:

Dividend / Initial price + Price change / Initial price/
Dividend yield
capital gains / losses yield

For the company cited above the dividend yield and the capital gains yield for 20X1 are as follows:

Dividend yield = 1.8 / 20.0 = 9 percent capital gains yield = 1.0 / 20.0 = 5 percent
Hence, the total yield for 20X1 was 14 percent.

Generally companies with low growth prospects offer a high dividend yield and low capitals gains yield. On the other hand, companies with superior growth prospects offer a low dividend yield and a high capital gains yield.

Market Value to Book Value Ratio: Another popular stock market statistic, the market value to book value is defined as:

Market value per share / Book value per share

Horizon’s market value to book value ratio at the end of 20X1 was:

21.00 / 17.47 = 1.20

This ratio reflects the contribution of a firm to the wealth of society. When this ratio exceeds 1 it means that the firm has contributed to the creation of wealth in the society – if this ratio is, say, 2, the firm has created a wealth of one rupee for every rupee invested in it. When this ratio is equal to 1, it implies that the firm has neither contributed to nor detracted from, the wealth of society.

It may be emphasized here that if the market value to book value ratio is equal to 1, all the three ratios, namely return on equity, earnings price ratio which is the inverse of the price earning ratio and total yield are equal.

Ratio: proposed by James Tobin; the q ratio is defined as

Market value of equity and liabilities / Estimated replacement cost of assets

The q ratio resembles the market value to book value ratio. However there are two key differences: (1) the numerator of the q ratio represents the market value of equity as well as debt, not just equity. (2) The denominator of the q ratio represents all assets. Further these assets are reckoned at their replacement cost, not book value.

Comparison with Industry Averages:

For judging whether the ratios are high or low, one has to make a comparative analysis such as a cross section analysis (in which the industry averages may be used as benchmarks) or time series analysis (in which the ratios of the firm are compared over time.

The industry averages often provide useful benchmark for comparisons. Sometimes the ratios of a few competitor firms may be used as benchmarks

Comparing the ratios with industry averages we find that:

1) Horizon Limited has a favorable liquidity position. All the liquidity ratios of Horizon Limited are higher than the industry average
2) Leverage ratios of Horizon Limited are a shade lower than the industry average.
3) Turnover ratios of Horizon Limited are more or less comparable with the industry average.

The following analysis proves this point:

Let B0 = book value per share at the beginning of the year
E1 = earnings per share for the year
D1 = dividends per share for the year
R1 = retained earnings per share for the year = E1 – D1
B1 = book value per share at the end of the year = B0 + E1 – D1
M0 market price per share at the beginning of the year = B0
M1 =market price per share at the end of the year = B1

Return on equity = E1 / B0

Earnings price ratio = E1 / M0 = E1/ B0

Market yield = D1 + (M1 – M0 ) / M0

= D1 + B1 – B0 / B0

= D1 + (B0 + E1 – D1) – B0 / B0 = E1 / B0

1) Profit margin ratios of Horizon Limited are somewhat higher than the industry average. The rate of return measures of Horizon Limited are also higher than the industry.
2) The valuation ratios of Horizon Limited compare slightly favorably in relation to industry average.