Columns AB – AE – Earnings per Share

Cameron : So column AB, what is the earnings per share? Now this is straight up financial data. Do you want to explain what EPS means?

Tony : Earnings per share the earnings part of the P/E ratio. It’s how much profit the company is making per share, divided by its share price. That gives us earnings per share.

Cameron : Okay. And we’re grabbing that number because in the next column, AC, we’ll look to see what analysts are saying the future earnings per share is. You don’t try to become an expert on the economics of a particular industry or sector or business, you don’t want to spend a lot of time drilling deep down into who their competitors are and what their R & D is like and whether they are leading the market and all that kind of stuff, which some people, do particularly full-time analysts who do that kind of stuff. What you do is go and look at what those professional analysts think the future earnings per share is going to be, and just take that. We take the summary of a consensus from a number of analysts, and use that as my shorthand calculation.

Tony : Correct. And just one more thing I’d say is that oftentimes the analysts are doing a shorthand calculation because they’re using the guidance from the company as well. So most large companies will say, we think our earnings per share next year is going to be X, Y, or Z or within a range.

Cameron : Wow. What do these analysts get paid to do then? Just read what the company says and republish it?

Tony : Think of new ways of obscuring how to invest so you can charge more fees? I don’t know.

Cameron : Okay, so that’s column AC again. So for the future EPS, you’re taking the estimate for the next period?

Tony : Correct. Sometimes the analysts will have estimates for the next two years, but I just take the next forecast period.

THE GROWTH OF THE EARNINGS PER SHARE

Cameron : Okay. So then in column AD I want to work out another formula. This is the growth of the earnings per share. We take the future earnings per share, subtract the current earnings per share, and then divide that result by the P/E. Now you’ve told me before that this little formula is something that you borrowed from the famous American investor, Peter Lynch. He reverses it and calls it the P/E over growth or the PEG ratio, but it’s essentially the same metric. And ideally, we want the growth of the earnings per annum to be close to the P/E. Why is that?

Tony : Well, Peter Lynch always thought this metric was the true intrinsic value for a company. So, taking into account its growth and what you’re paying for it now, he thought that when they were equal, that was the right price to pay. Basically, what he’s saying is that you should pay more for a company that’s growing quickly and pay less for a company that’s growing slowly. So the P/E over growth should be equal to one. If the growth is only 10%, the P/E should be 10. And if the growth is 20%, then the P/E should be 20. So, it’s basically saying you can pay more for a growing company.

Cameron : Okay. So, in the next column, AE, we ask if the growth over P/E higher than 1.5? If it’s a yes, it gets a one. If it’s a no, it gets a zero. And if it’s a negative result, it gets a minus one. Why the 1.5 number?

Tony : I’ve probably inverted Peter Lynch’s number here, but if you do it the other way around, he’s looking to buy things that are less than one. I came across it in a different presentation from a stockbroker and they inverted it and used 1.5. So that’s what I’ve adopted in my checklist.

Cameron : So, in essence, we’re using this to determine if the company’s earnings are growing faster than the price to earnings ratio?

Tony : Well, we’re trying to find a company that’s growing at 20%, but it’s P/E is only 10%, so it’s fast growing, but we’re not paying as much for it as that growth would indicate we should pay for it.

Cameron : Right, we’re getting it at a discount. What I meant to say is that it’s growing faster than what the current P/E is, so the current P/E isn’t taking into account the future growth.

Tony : Yes, that’s right, correct. Again, it’s another indicator of value.

Cameron : So, we think this business’s earnings are going to grow, so the P/E will grow. The P/E a year from now will probably be different to what it is today, but if we can buy it today at that price, and it’s not factoring in what the earnings are going to be a year from now, we’re getting it at a good price.

Tony : Correct. It’s cheaper.

Cameron : That sounded convoluted but I understood what I meant.

Tony : I was just going to say, I think one thing that might be becoming clear is that we don’t just have one way of valuing a company. And I have found that there is no single KPI, or no single metric, that is a great indicator of quality or value. What we’re trying to do is build a kind of heat map of all different things that are scoring. And then if stocks score on a number of different fronts, whether it’s book value, or book value plus 30%, or growth over P/E ,all those kinds of things, then the score goes up. So,we’re not really focusing on one metric over any other metric.

Cameron : You’re like a doctor that’s listening to their chest, taking their temperature, taking their heart rate, doing some blood work, sticking your finger up their bum to check the prostate. You know, you’re fondling, you’re squeezing, checking. You’re doing a full checkup.

Tony : That’s right. Just like a doctor.