John Jeffery
John Jeffery

In my last article, I began preparing you all for a look into ValueGain and fundamental analysis (I also wished luck to the Socceroos and England, but we need not mention that!!). We broached the ideas of qualitative and quantitative information and how numbers from the financial statements can be used to analyse stocks. I know that many people will already be asking about the value of these numbers. A profit of $10 million might sound like a lot, but what happens if the profit last year was $10 billion? Does it still sound so good? In fact, is there any advantage at all in looking at these absolute figures? It is an astute point, and because of this you will find many quantitative analysts prefer to use “ratios” to ‘normalise’ a particular company’s data.

Ratio analysis isn't just about comparing different figures from the income statement, balance sheet and cash flow statement. It's more about comparing the figures against previous years, other companies, the industry, or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past - and might perform in the future. For example, by looking at a company’s sales divided by its market capital, you get an immediate idea of how much an investor is willing to pay for every dollar of sales made. Although we will cover many of these ratios (and more) over the next few weeks I want to start in familiar territory, the well known and much loved P/E ratio.

Several ratios are easy to calculate and easy to use when it comes to the quick decision making and analysis of a trader. The P/E ratio is probably the best known and most easily acquired ratio. Sometimes called the multiple, the P/E is often thought of as a bit of a dirty ratio and is open to some differences in interpretation, but for a ‘quick glance’ it provides some instant information. To calculate the P/E ratio is simple enough:

P/E = Share Price
            EPS

Where: EPS = Earnings per Share

The idea behind the P/E ratio is that it is a prediction, or to use a better phrase, an expectation of the company’s performance in the future. A higher P/E would suggest that market participants are expecting big things from a share, compared to one with a lower P/E. A quick check of the average P/E of the overall market and comparison to the P/E of your share, will also reveal a bit more; if the P/E is much greater than the average, the bulls have a vested interest and are looking to see a ramp up in the price.

In the example below, it’s pretty obvious to see that General Motors (GM) in the US has had a real drop-off in the P/E ratio. The blue histogram is clearly decreasing in size over the years in question. We can assume that the bears are expecting a fall in price over that same period.

Chart 1 – GM Ratio Analysis

chart
click chart for more detail

Check the price action on your software over the same time period from 2001. Interesting stuff this fundamental analysis! There are some issues with the P/E ratio, however. Nothing is foolproof and we can see some limitations in this particular ratio.

The P/E is notoriously problematic due to several accounting points. Earnings (for the EPS component) can either be forecasted or historical. Past earnings are already out of date (!) and future earnings are often subject to manipulation on the balance sheet!

To really get the most value from the P/E ratio it is best to combine it with other ratios and analysis. Watch this space for the next ratio as we build a sound trading model.

 

Stay Sharp,

John Jeffery