Understanding two common numbers in investing

ONE of the challenges of evaluating stocks is establishing an "apples to apples" comparison. What this means is setting up a meaningful comparison so that the results help you make an investment decision.


Comparing the price of two stocks doesn't work because companies have different number of shares. Comparing the earnings of one company to another also doesn't work for the same reason.


For example, companies A and B both earn RM100, but company A has 10 shares issued, while company B has 50 shares. Which company's stock do you want to own?

It makes more sense to look at earnings per share (EPS) for use as a comparison tool.


You calculate earnings per share by taking the net earnings and divide by the outstanding shares.


EPS = Net Earnings / Outstanding Shares

Using our example above, Company A had earnings of RM100 and 10 shares outstanding, which equals an EPS of 10 (RM100 / 10 = 10). Company B had earnings of RM100 and 50 shares outstanding, which equals an EPS of 2 (RM100 / 50 = 2).


Now you understand EPS, there's another acronym you'd want to know-P/E.


If you hang around investors and brokers long enough, you'd hear the word P/E a lot. It means a Price to Earnings ratio and it is the one number people look at most. It doesn't telwl you everything about a company but it tells a lot.


The P/E looks at the relationship between the stock price and the company's earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.


You calculate the P/E by taking the share price and dividing it by the company's EPS (earnings per share).


P/E = Stock Price / EPS

For example, a company with a share price of RM4 and an EPS of 8 would have a P/E of 0.5 (RM4/ 8 = 0.5).


What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the company's earnings. The higher the P/E the more the market is willing to pay for the company's earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock's future and has bid up the price.


On the other hand, a low P/E may indicate that people don't like the stock but it could also mean that it is ripe for investment because many people have overlooked it. Some investors make a lot of money spotting these `sleepers' before other people.


What is the "right" P/E? There is no correct answer to this question. It depends on your willingness to pay for earnings. If you think it has good long term prospects you won't mind and that it's performance in the future is above its current position, the higher the "right" P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your "right" P/E is all wrong.