Talk in the equity market has always been full of strange jargon and abbreviations. A normal person has quite a struggle to make sense of this weird language or rather an alien sound for him/her. Whether we talk or read of the fundamental, technical or environmental analysis, we end up coming across such words, phrases and abbreviations again and again. Here I try to make sense of a few such words.
Every time we read through the financial reports of a company, we come across ‘Earnings Per Share’ (EPS). This EPS is, of course, not about the permit system for an employment in Korea. It is rather about how much money each individual unit of the share has made for the owner. The shareholder invests in the shares of a company with a hope of a good future return. EPS provides them with an understanding of how much return they can expect from each unit of share after the company deducts all the associated costs.
EPS is calculated by dividing a company’s distributable or net profit by the number of outstanding shares (total number of shares owned by the promoters and the public combined). EPS informs us whether the company is profitable or not. Therefore, a share with a higher EPS is seen as more profitable. But higher EPS alone does not guarantee a good dividend. In most situations, a company will have to set aside a portion of net profit into different reserve funds and only a fraction of the net profit can be distributed as dividend.
‘Price-to-Earnings Ratio’ (P/E Ratio) examines the current market rate of the scrip in comparison to its EPS. It helps people assess if the prevailing market rate of a scrip is ‘expensive or cheap’ in relation to the earnings it makes. P/E ratio shows how many times of the earnings the people are willing to pay for the scrip. This ratio is derived by dividing the current market rate of the scrip by the EPS. During bullish markets, P/E ratio of almost all the scrips—even the fundamentally weaker ones—report high P/E ratio. Investors have very positive outlook of the market during the bullish run.
They do not think twice about doling out more money for the scrip having relatively less EPS. The rationale is the greed and expectations of never-ending price increment. This immediately reflects in high P/E ratio. During the bearish markets, people are unwilling to pay even the ‘fair price’ for the scrip and the P/E ratio starts to decrease. This is when smart investors start to accumulate the shares of fundamentally stronger companies.
P/E ratio is primarily used to compare the relative market price of different scrips within the same industry. It is also used to compare the prevailing market rate of the scrip with the historical record to determine if it is the right time to buy or sell. The table above compares EPS and P/E ratio of a few scrips of commercial banks from the same segment to determine which has the higher EPS but lower P/E ratio.