If you read this column last month you may recall that we were using
the chart below to get a feeling for the local market, particularly how
the companies’ earnings relate to their dividends. In this final
installment of By the Numbers we’ll take a quick look at the Price to
Earnings ratio (the column called P/E) and see what we can learn from
that.
Basically, P/E tells us how many shillings investors are willing to pay
for every shilling that a company earns. So what does that exactly
mean? Say that two companies each calculate their total profit at the
end of the year and then they divide their earnings by the number of
the shares they had distributed to the public. Let’s also say that, by
chance, each company found that their annual profit amounted to 100
TShs per share. If this were the case, then the company with the higher
stock price would also have the higher P/E.
Now, on the face of it, you might wonder why you would pay more for the
same amount of earnings per share…and that’s a fair question, so let’s
try to explain. Basically, the reason people are willing to pay more
for a stock with a higher P/E is because they are anticipating that
this company’s earnings will rise more quickly then will the earnings
of a company with a lower P/E. In other words, a high P/E can be a
signal that market-watchers are anticipating solid growth, and solid
growth is what creates value in a stock (and therefore, it is a stock
you want to own).
 From the DSE
But a high P/E can also result from something else. If a company’s
stock price were to remain constant while their profit unexpectedly
fell, the P/E would also rise. Needless to say, the market takes a dim
view of this type of P/E inflation, as it doesn’t reflect a belief in
the strength of future earnings at all. Of course the problem is, it
can be difficult to determine exactly what a high P/E is telling us if
we don’t know which of these key factors was involved.
So with all this in mind, let’s take look at the chart again. In your
opinion, which of these companies is really the most likely to grow? Go
ahead, grab a pencil and order the companies from ‘most to least’
likely to grow – give it your best guess. Now look at the order
established by their P/E. Are there differences between how you ranked
them and how they are ranked based upon P/E? Whose growth predictions
do you think are more likely to come true? That’s important because you
want to be investing in the companies you most expect to grow.
In summary then, what we’ve seen is that the publicly traded companies
provide audited financials statements to allow shareholders and
prospective shareholders to analyze a company’s potential for
delivering some mixture of returns and growth. Numbers can go a long
ways in helping us make buy and sell decisions, but they still tell
only a part of the story. The ‘business environment’ is key as well,
and that’s what we’ll talk about next month. Until then, remember,
regardless of how much you study the numbers, the secret to the market
remains unchanged: buy low – sell high!
Michael Gehron
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