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How to pick valuable stocks

March 26, 2008 12:27 IST

Earnings is the yardstick by which companies are finally judged, namely what investors earn on their investments. Accordingly, earnings ratios are popular tools for determining the fair market price of a share and to discover valuable investments.

Earnings per share

The earnings per share (EPS) ratio indicates the earning of a common share in a year. This ratio enables investors to actually quantify the income earned by a share, and to determine whether it is reasonably priced. The ratio is arrived at by dividing the income attributable to common shareholders by the weighted average of the number of common shares.

In countries, including India, where employees are given stock options, investors check a company's fully diluted earnings per share. This is the earnings per share of a company after all share options, warrants and convertible securities outstanding at the end of the accounting period are exchanged for shares.

Many investors also value a share as a multiple of the earnings of the company. If the earning per share is Rs. 5 and a yield of 10 per cent is considered reasonable, the share is priced at Rs. 50.

Cash earnings per share

It is often argued that the earnings per share is not a proper measure of the earning of a company since depreciation, tax and the cost of finance varies from one company to another.

Illustration
In 2007, the earnings after tax of Range View Tea Estates were Rs. 5,00,000. Between 1 January 2007 and 30 June 2007 the company had 2,00,000 shares of Rs. 10 each outstanding. On 1 July 2007, the company issued an additional 1,00,000 shares.
The earnings per share of Range View would be:

The true earnings, the argument goes on, should be calculated on the earning before depreciation, interest and tax. The cash earning per share is arrived at by dividing earning before depreciation, interest and tax (EDBIT) by the weighted average number of shares issued.
The cash earnings per share will always be more than the earnings per share.

Illustration
The summarised Profit and Loss Account (Income Statement) of Nikhila Chips Ltd. for the latest financial year was as follows:
Rs. (lakh) Rs. (lakh)
Sales  5,000
Cost of goods sold  3,000
  ---------
Gross Income  2,000
Selling costs 300
* Administration Expenses 200 500
-------- ---------------
Net Income  Rs. 1,500
  ========

* Administration expenses includes interest costs of Rs. 40
and depreciation of Rs. 20.
The company had issued 500,000 shares of Rs. 10 each.
The cash earning of a share in Nikhila Chips Ltd.
would therefore be:

Dividend per share

Investors often use the dividend per share as a measure to determine the real value of a share. Proponents of this school of thought argue that the earning per share is of no real value to anyone but those who can determine the policies of a company. The income of an investor is the dividend that he receives. It is therefore submitted that the value of a share should be a multiple of the dividend paid on that share.

How does one value a share? If one assumes that the gains made by an investor would include an increase in the price of the share, i.e. capital appreciation, and dividend income per share, the price would depend on the capital appreciation one expects. If the share has regularly appreciated by 30 per cent every year, a low dividend yield would be acceptable.

Illustration
The share of Divya Jeans Ltd., which has a market value of Rs. 40, has appreciated during the last three years by an average percentage of 25. If an investor were aiming at a yield of 30 per cent, a dividend of 5 per cent would be adequate. In such a scenario if Divya Jeans has paid a dividend of 15 per cent, its market value on the basis of dividend per share would be (assuming 15 per cent dividend on the face value = 5 per cent on the market value) as follows:

On this basis the shares of Divya Jeans is overpriced.

Conversely, if a share does not appreciate by more than 5 per cent and a 30 per cent return is required, a high dividend yield would be expected.

If the shares of PDP have been appreciating at 7 per cent per annum and the company declares a dividend of 30 per cent or Rs 3 per share the real value of the share would be (30 per cent dividend will be construed as a yield of 23 per cent).

It must be noted that this method of valuation is so ridden with assumptions (appreciation every year and expected return) that it is rarely used.

Dividend payout ratio

The dividend payout ratio measures the quantum or amount of dividend paid out of earning. This ratio enables an investor to determine how much of the annual earnings are paid out as dividend to shareholders and how much is ploughed back into the company for its long-term growth.

This is an important ratio when assessing a company's prospects because if all its income were distributed there would be no internal generation of capital available to finance expansion and to nullify the ravages of inflation and to achieve these the company would have to borrow.

This ratio is calculated by dividing the dividend by net income after tax.

Illustration
Excel Railings Ltd.'s earnings after tax in the last financial year was Rs. 68 lakh. Of this, it paid a dividend of Rs. 28 lakh. Its dividend payout ratio would be 28/68 = 0.412.

The company distributed 41.2 per cent of its net income as dividends, retaining 58.8 per cent in the business for its growth.

Normally, young, aggressive growth companies have low dividend payout ratios as they plough back their profits for growth. Mature companies, on the other hand, have high payouts.

This is of concern as they may not be retaining capital to renew assets or grow. Investors must also ensure that the dividend is being paid out of current income and not out of retained earnings because that tantamounts to eating into the funding set aside for growth, expansion and replacement of assets.

Summary

It is important to remember that earnings ratios are not indicators of profitability. They advise an investor on the earnings made per share, the dividend policy of a company, and the extent of income ploughed back into the company for its expansion, growth and replacement of assets.

It is critical that investors examine these ratios, especially the earnings per share and the dividend payout. The earnings per share would help one determine whether the market price of a share is reasonable. If the dividend payout ratios are very high investors must be concerned as it can indicate that the management of the company is not particularly committed to its long-term growth and prospects.