interested in. This could have been due to the limited information published in what we now call an IPO (Initial Public Offering) (this term is itself only about twenty years old). The only information a purchaser of a new issue would likely get would be profits averaged over several years (to even out the ups and downs), money available to pay the ordinary dividend after paying the preferred shareholders, and the balance sheet. Given the limited information made public in those days, it is not surprising that a more sophisticated analysis of company earnings was not yet possible.
The US in the 1920s: enter the P/E
DY in the US maintained its hold until the mid-1920s. The P/E only really became popular during the boom years of the late 1920s. Earnings themselves had boomed since the Great War. People were more interested in earnings growing at 10% or 25% annually than dividends growing at 5%. Everyone believed that this long-term growth could be kept up indefinitely due to rapid technological change. US company accounts were also generally more informative than in the UK, so that investors in US companies could see what was happening to retained earnings. They could appreciate the fact that the effect of compound interest on a company’s growing reserves would mean higher dividends and hence higher share prices in the future. Ben Graham and David Dodd could already comment in their 1934 classic Security Analysis:
Common stocks have come to depend exclusively on the earnings exhibit.
Catching up with the US
Meanwhile, DY remained for decades the main valuation ratio in the UK. Earnings were overwhelmingly paid out as dividends, whereas in the US a significant proportion was held back as undistributed profits. UK corporate earnings had themselves not shown the long-term rapid growth that US companies had experienced, so the gap between the two valuation methods was not as marked.
Relatively uninformative UK company accounts did not help: consolidated accounts (reporting the group’s overall position rather than individual companies within the group) were not compulsory until 1948, and even something as basic as turnover did not legally have to be disclosed until 1976. As a result you could find analysts in the same research note covering US stocks in an industry by looking mainly at their P/E, but the UK stocks in the same industry by mainly considering their DY.
It was not until 1965 that UK investors really caught up with the US in their use of valuation ratios. The introduction of corporation tax in that year meant that companies and individual shareholders were finally treated as separate taxable entities. Until then, companies had paid income tax on behalf of their investors, who might have to pay further tax depending on their level of income. Thus it was difficult to estimate company income after company taxes but before personal taxes. By 1966 The Economist was already valuing many UK companies using their P/Es.
The P/E today
Amongst practical investors the P/E has maintained its popularity since then. However, there are two areas in which the P/E has been eclipsed in recent years. Interest in it from finance academics has been limited since Eugene Fama and Ken French decided in the early 1990s that price-to-book value was a better indicator of value stocks and dropped the P/E from their now widely popular three factor model. (See later chapter.)
The other time the P/E has become little used has been during stock market bubbles. This is ironic considering that the P/E itself only came to prominence during the 1920s’ boom in the US. Some extraordinary P/E ratios occurred during the dot.com mania: America Online reached a P/E of 275 and Yahoo a P/E of 1900.
Extraordinary P/Es in the hundreds or thousands are telling investors that they are building castles in the sky, but during bubbles that is precisely the message that investors don’t want to hear.
Chapter 2. Earnings
Before we can cover the P/E itself, we should first define its more complicated component: earnings. This chapter covers the basics of the different ways in which earnings and then earnings per share (EPS) can be defined. I move downwards through the profit and loss account and discuss the different figures as more and more costs are deducted from profits. The discussion is purposely kept general here; for a practical example, see the later chapter on Haynes. I do not intend to give a detailed explanation of company accounts, as many other books do this; I cover only the components of the earnings calculation.
From sales to operating profit
The basics need little explanation.
A company produces goods or services and sells them; the amount the company receives here is termed the sales (or turnover, or revenue). From this figure of sales we need first of all to deduct the cost of the items sold to calculate the gross profit.
However, we have not yet reached the first figure that counts as earnings, because many expenses must be taken into account on top of raw materials, such as staff costs, IT, rent and so on. Other notional expenses, such as depreciation and amortisation, are also deducted. These are not necessarily items that have caused us to actually spend any cash this year, but they need to be deducted regularly from gross profit in any case. Declared profits would be excessively variable if large occasional expenditures on capital items were recorded as they happened. There is anyway a separate Consolidated Cash Flow statement.
‘Earnings’ as a word on its own is in fact a rather ill-defined catch-all term for any of the profit figures we now cover. The initial figure for earnings is the difference between revenue and the total of these costs – basically all the costs of the company excluding finance charges and tax. This initial earnings figure is called operating profit.
Towards the P/E’s earnings figure
Operating profit is the highest figure up the profit and loss account that is referred to as ‘earnings’. However, there are two unavoidable costs of running a business that still remain to be taken out: interest paid to service loans, and tax. Subtracting interest paid gives profit before tax. Finally subtracting tax paid gives profit from continuing operations. (Details of any discontinued operations will appear in a separate column in the profit and loss account.)
Now all the necessary deductions have been made to the profit, a ‘clean’ figure is available to distribute to shareholders or into the company reserves. It is this profit from continuing operations that is used in EPS calculations.
EBIT and EBITDA
These ungainly acronyms have become increasingly popular in recent years. EBIT stands for earnings before interest and tax, and EBITDA for earnings before interest, tax, depreciation and amortisation. There are times when they may legitimately be used. For example, EBITDA is often used in loan covenants, partly because the bondholders are not concerned about tax payments – interest payments are made before a company’s tax liability is calculated.
However, it is hard to avoid the impression that EBIT and EBITDA have become so widely quoted because they make every company’s earnings look better. It is always a bad sign to come across a company proudly quoting its EBITDA in the first few pages of graphics in its annual report, instead of profit figures from further down the profit and loss account. Often a few seconds with a calculator will show that the company has little or no chance of ever making a real profit, because its amortisation charges more than wipe out the operating profit each year.
EBIT and EBITDA
