The earnings season is almost here, and at a good time too, considering that share prices are again flying high. Share prices are primarily driven by the earnings of companies, and now is a good time to check if the share prices of the companies (stocks) you own are in line with their (the companies') earnings.
For this, one would have to start with the bottom of the earnings report where the EPS or the earnings per share is found. Dividing a company's share price by its EPS gives the price-earnings ratio (PE), which although shouldn't be used as a magic number, gives a fair idea on the valuation of a company relative to peers in the industry or the market as a whole.
For instance, Hero Honda is expected to report an EPS of Rs 41 per share for the year ended March 2005. At its current price of around Rs 550, this gives it a PE of around 13.4 times FY05 earnings.
On the other hand, Infosys Technologies is expected to report an EPS of close to Rs 70 per share in FY05, which gives it a PE of over 32 times based on its current price levels (Rs 2,240).
Evidently, Infosys is more expensive relative to Hero Honda, but there are reasons for this. Earnings at Infosys are expected to grow at a faster pace in the future relative to Hero Honda. Which brings us to the PEG ratio, calculated by dividing the PE ratio by the earnings growth of a company.
A PEG ratio of 1 is normally seen as fair valuation and anything above that is expensive.
Thus, if Infosys is being valued at over 32 times earnings, but it's expected earnings growth is less than 32 per cent on an average in the future, it would be overvalued based on the PEG ratio.
The PE and the PEG ratios serve as important benchmarks while comparing stocks within an industry. Market leaders in the industry normally get a premium valuation relative to smaller players.
Therefore, one needs to be cautious when, say, as a shareholder of Kinetic Motors or LML, you find that the PE of your company is much higher than Hero Honda, which is the market leader in the two-wheeler industry.
As much as the EPS is important to determine the relation a company's share price has with its earnings, it's equally important to assess the quality of a company's earnings. To start with, one needs to check if growth in sales/revenues is healthy by comparing it with industry growth.
Ideally, growth parameters need to be looked at over at least a three year period. This would help especially in times when there are wide fluctuations in growth rates because of some extraordinary circumstances.
Next, one needs to check the impact the growth in sales or the lack of it had on profit growth. For this, it would be best to use the profit figure before accounting for other income, interest, depreciation and tax.
This is known as the operating profit of the company, and as a percentage of sales it's known as operating margin. Essentially, operating margin = operating profit/sales x 100.
An improvement in operating margin is a good sign, which could indicate a number of factors including economies of scale, better cost management, pricing power, etc.
Decline in margins, on the other hand, could be on account of low pricing power or the inability to pass on higher costs, cost overruns, etc.
Again, it makes sense to look at the trend within the industry. In some cases, there may be an increase in operating profit margins because of aggressive cost cutting in areas such as advertising and promotion, but this may hurt the company in the future as these expenses normally lead to sales in the future.
Also, some companies may manage earnings growth only through rationalisation in costs and not through increase in sales. This is not a healthy sign, since there is a limit to which cost cutting is possible. In the long run, profit growth can be sustained only through a growth in revenues.
One should also check the contribution made by other income to the profit. This can be done by looking at it as a proportion of profit before tax (other income/PBT x 100). A big jump in this metric isn't a healthy sign, since it may not be repeated in the future.
Therefore, it's necessary to check the source of the other income and whether it would continue even in the future. Bajaj Auto's other income, for instance, accounts for over 35 % of the company's profit before tax, which is high compared to most other corporates.
However, the source of the other income is mainly treasury related thanks to the high amount of investments the company has. Because of this, other income is not expected to drop drastically, and is hence not a concern at least as far as its impact on earnings go.
What one needs to watch out for are extraordinary, one-time sources of income. In fact, while calculating the EPS, it would make sense to exclude these extraordinary sources of income.
One also needs to keep an eye on the interest and depreciation figures of a company, probably as a proportion of sales. These expenses could shoot up in case of capital expenditure undertaken by the company.
What an investor needs to check is if such expenditures are delivering desired returns, in terms of in sales either in unit terms of revenues terms. Finally, even though earnings may have gone up, one may find that the EPS is pretty much constant.
This can happen if there was also an increase in the company's equity capital, because of which the earnings attributable to each equity shareholder would be lower.
In summary, look at what's driving earnings growth or the lack of it at the company and for measures taken by the company that will impact earnings growth in the future.
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