Reading Financial Reports for Dummies (30 page)

Earnings per share represents the amount of income a company earns per share of stock on the stock market. The firm calculates the
earnings per share
(EPS) by dividing the total earnings by the number of shares outstanding.

Companies often use a weighted average of the number of shares outstanding during the reporting period because the number of shares outstanding can change as the company sells new shares to outside investors or company employees. In addition, companies sometimes buy back shares from existing shareholders, reducing the number of shares available to the general public.

A weighted average is calculated by totaling the number of shares available during a certain period of time and dividing that number by the number of periods included. For example, if the weighted average is based on a monthly
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average, the number of shares outstanding on the stock market at the end of each month is totaled and divided by 12 to find the weighted average. This can also be done with a weekly or daily figure. If weekly stock totals are used, the total of these periods would be divided by 52. If daily numbers are used, the total would be divided by 365.

Calculating the P/E ratio

To get the P/E ratio, divide the market value per share of stock by earnings per share of stock:

Market value per share of stock ÷ Earnings per share of stock = P/E ratio You can find the market value per share of stock on many Web sites. Yahoo!

Finance (finance.yahoo.com) is one of my favorites for easily finding historical stock data.

The P/E formula comes in three flavors, which vary according to how earnings per share is calculated: trailing, current, and forward earnings.

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Trailing P/E:
You calculate a trailing P/E by using earnings per share from the last four quarters, or 12 months of earnings. This number gives you a view of a company’s earnings ratios based on accurate historical data.

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Leading or projected P/Es:
The other two types of P/E ratios are calculated using analysts’ expectations, so they’re sometimes called “leading”

or “projected” P/Es.

•

The

current P/E ratio
is calculated using earnings expected by analysts during the current year.

•

A

forward P/E ratio
is based on analysts’ projections for the next year.

Any P/E ratio that uses future projected results is only as good as the analyst making those projections. So be careful when you see the terms
leading, projected, current,
or
forward P/E.

Any type of P/E ratio is just one of many profitability ratios you should consider. This ratio gives you a good idea of what the public is willing to pay per share of stock based on the company’s historical earnings (trailing P/E) or what the analysts project you can consider paying per share of stock based on future earnings (current P/E or forward P/E). It gives you no guarantees about what the company will earn or what the stock price will be in the future.

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Part III: Analyzing the Numbers

Practicing the P/E ratio calculation

Now that you understand the basics behind the P/E ratio, I show you how to calculate it using real-world numbers from Hasbro and Mattel. As I mention earlier in this chapter, the company calculates earnings per share, which represents the total earnings divided by the number of shares outstanding.

Remember that the number of shares outstanding can change as the company sells new shares to investors or buys them back from existing shareholders.

When a company reports its earnings per share, it usually shows two numbers: basic and diluted. The firm calculates the
basic EPS
using a weighted average of all shares currently on the market. The
diluted EPS
takes into consideration all future obligations to sell stock. For example, this number takes into account employees who have stock options to buy stock in the future, or bondholders who hold bonds that are convertible to stock.

To practice using the formula to calculate P/E ratios, I use numbers from Mattel’s and Hasbro’s income statements. Table 11-1 shows Mattel’s basic and diluted EPS for 2007, 2006, and 2005. Table 11-2 shows the same information for Hasbro.

Table 11-1

Mattel’s Earnings per Share (EPS)

Net Income (Loss)

Earnings per Share

2007

2006

2005

Basic

1.56

1.55

1.02

Diluted

1.54

1.53

1.01

Table 11-2

Hasbro’s Earnings per Share (EPS)

Net Income (Loss)

Earnings per Share

2007

2006

2005

Basic

2.13

1.38

1.19

Diluted

1.97

1.29

1.09

In the following examples, to calculate how the public valued the results for Mattel and Hasbro at the end of May 2008 using the 2007 annual report, I use the stock price at the time the market closed on May 30, 2008. I also use the diluted earnings per share, which more accurately represents the
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company’s outstanding shareholder obligations. Mattel closed at $20.14, and Hasbro closed at $36.24. Even though Mattel’s diluted earnings per share were just 43 cents per share lower than Hasbro, Hasbro’s stock sold for $16.10 more per share.

Here’s Mattel’s P/E ratio:

$20.14 (Market value) ÷ $1.54 (2007 Diluted EPS) = 13.08 (P/E ratio) Note that the P/E ratio is shown without a dollar sign. P/E is not a dollar value but instead shows the number of times the price outweighs the earnings of the company.

So Mattel investors are willing to pay $13.08 for every $1 of earnings by Mattel in 2007. Following is Hasbro’s P/E ratio:

$36.24 (Market value) ÷ $ 1.97 (2007 Diluted EPS) = 18.4 (P/E ratio) Hasbro investors are willing to pay $18.40 for every $1 of earnings by Hasbro in 2007.

As you can see, Mattel’s stock was beaten down by the recalls of toys from China in 2007 and has not fully recovered. Even though its earnings per share were just 57 cents less per share, the amount investors are willing to pay for its stock is $5.32 less per dollar of earnings.

Using the P/E ratio to judge company

market value (stock price)

In comparing Mattel’s and Hasbro’s P/E ratios, you can conclude that on May 30, 2008, investors believed that Hasbro had better chances of improving its earnings performance than Mattel and, therefore, were willing to pay a higher price for each share of Hasbro’s stock. You must dig deeper into the numbers, the quarterly reports for the first half of 2008, and general financial press coverage to determine why investors are more bullish on Hasbro than Mattel. But this one quick calculation lets you know which stock investors favor.

How do you know what a reasonable P/E ratio is for a company? Historically, the average P/E ratio for stock falls between 15 and 25. This ratio depends on economic conditions and the industry the company’s in. Some industries, such as technology, regularly maintain higher P/E ratios in the range of 30 to 40.

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In addition to comparing two companies, you should compare the P/E calculation to the industry in which the companies fall. Doing so allows you to gauge stock price or market value not only for the companies whose annual reports you’re analyzing but also for other companies in the same business.

One way you can find out the average industry P/E is to look up a company on Yahoo! Finance (finance.yahoo.com). On its home page, you see a link for industry information. Toy companies fall in the Toys & Games industry category. The average P/E for the Toys and Games industry was 19.7 in June 2008, so both Hasbro and Mattel had P/Es below the industry average.

The P/E is a good quick ratio for picking potential investment candidates, but you shouldn’t use this ratio alone to make a buying or selling decision. After you pick your targets, read and analyze the annual reports and other information about the company before making a decision to invest.

If you want to start your research on potential investment opportunities based on leaders or laggards in an industry, you can find a summary for all industry statistics at biz.yahoo.com/ic/index.html. You may wonder why someone would even consider laggards as investment opportunities. Well, that’s where you can sometimes find a company that many investors think is a dog but in reality is terribly undervalued and doing the right things to recover from its current slump. This style of investing is called
value investing.

When investors are bullish, they tend to bid up the price of stock and end up paying higher prices for the stock than it may actually be worth. This price-bidding war also drives up the P/E ratio.

Stock prices are set by the market based solely on the price at which someone is willing to sell a stock and the price at which someone is willing to buy a stock.

During the Internet and technology stock bubble of the late 1990s and early 2000s, P/E ratios hit highs in the hundreds and tumbled dramatically after the bubble burst. Even big names, such as Microsoft, had P/E ratios over 100 that dropped back to realistic levels when the bubble burst. In July 2004, Microsoft’s P/E was 41.37, so you can see that even a top company can be seriously overbid by investors. By June 2008, Microsoft’s P/E dropped dramatically to 16.14. Microsoft is no longer flying as high. Its new operating system, Vista, didn’t do as well as expected, and the losses in the European courts hurt the company’s future earnings potential. Investors are no longer willing to overpay for its stock.

Be careful when you see P/Es creeping above their historical averages. Usually you’re encountering a sign that a correction is looming on the horizon, which will bring stock prices back down to realistic levels.

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Understanding variation among ratios

You’ll probably find varying P/E ratios for the same company because the number used for EPS can vary depending on which method for calculating EPS the company chooses. The diluted EPS is the one you should generally use. This figure is based on the current number of shares on the market, as well as those promised to employees for purchase in the future and those promised to creditors that may decide to convert a debt into a stockholding (if that’s part of the debt agreement). So diluted earnings gives you the most accurate picture of the actual earnings per share of stock now available on the market or committed for sale in the future.

But when companies put out a press release, they tend to use whatever EPS

looks most favorable for them. Companies can choose among four basic ways to calculate EPS:

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Reported EPS:
Companies calculate this EPS number by using general accounting principles and report it on the financial statements. They show it in two formats: basic and diluted. Most times, the diluted EPS

number is the best one to use, but sometimes it can be distorted by one-time events, such as the sale of a division or a one-time charge for discontinued operations. So you need to read the notes to the financial statements to determine whether the EPS figure needs to be adjusted for unusual events. Chapter 9 discusses the notes to the financial statements in great detail.

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Pro forma EPS:
You almost always find this EPS in a company’s press release because it makes the company look the best. In most cases, this figure excludes some of the expenses or income the firm uses in the official financial reports. The company adjusts these official numbers to take out income that won’t recur, such as a one-time gain on the sale of marketable securities, or expenses that won’t recur, such as the closing of a large division.

When a company mentions Pro forma EPS or statements in its press release, be sure that you compare these numbers with what the company develops using generally accepted accounting principles (GAAP) and reports in the financial statements filed with the Securities and Exchange Commission (SEC).

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Headline EPS:
This EPS is the one you hear about on TV and read about in the newspapers. The earnings per share numbers used may be basic EPS, diluted EPS, Pro forma EPS, or some other EPS calculated based on analysts’ projections, so you have absolutely no idea what’s behind the numbers or the P/E ratio calculated using it. It’s likely the most unreliable EPS, and you shouldn’t use it for your evaluation.

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Cash EPS:
Companies calculate this EPS by using
operating cash flow
(cash generated by business operations to produce and sell its products). Operating cash can’t be manipulated by accounting rules as easily as net income, so some analysts believe this EPS is the purest. When you see this number, be sure it’s based on operating cash and isn’t just a fancy way of saying EBITDA (earnings before interest, taxes, depreciation, and amortization). You can judge this by calculating the Cash EPS

using the EBITDA reported on the financial statements and the net cash from operations reported on the statement of cash flows. Only the net cash figure gives you a true picture of cash flow.

The P/E ratio is an ever-changing number based on the day’s market price.

It’s also a number that’s hard to depend on unless you know the calculations behind it. Companies can calculate the earnings per share in many different ways — using basic EPS, diluted EPS, Pro forma EPS, cash EPS, headline EPS, and projected or leading EPS. Reading the financial reports and checking the calculation for yourself is the only way that you can truly determine a company’s P/E and what’s included in its calculation.

The Dividend Payout Ratio

The dividend payout ratio looks at the amount of a firm’s earnings that it pays out to investors. Using this ratio, you can determine the actual cash return you’ll get by buying and holding a share of stock.