Why price earnings ratios don't always tell you the full investment story

In the tables at the foot of each new recommendation and my commentaries, I refer to the company's 'PE'. This is short for the price earnings ratio. The price is simply the current share price and the earnings are the number of cents the company earns in its financial year for each share.

This particular measure of value has stood the test of time because it's objective and fairly simple to understand. Let's have a look at how this works out: Company A made a profit before tax of R2.49 million. After paying tax of R1.47 million, it had R1.02 million left. 

There are 24.6 million shares in issue, so dividing that number into R1.02 million gives us an earnings per share of 4.15c. Taking a share price of 105c, the PE ratio is 25. Put another way, your share earned a post-tax return of 4% (4.15c/105c) last year. That is not a great deal and wouldn't justify holding Share A unless either the 4.15c figure will grow quickly in the future, or the 4.15c figure hides a better story.The PE can be a blunt instrumentBut now here comes the all-important thing. Although the figures above come from the most recent balance sheet or earnings report issued by the company, they're historic and reflect the earnings situations of the last reporting period (either annual or interims). Now, here is the issue... stock markets are always forward looking, pricing and factoring in tomorrow's financial situation today. So if earnings reports are historic in nature and the markets are forward looking, we have a significant problem. The earnings fundamentalist (one who makes his investment decisions based on the financial fundamentals of the balance sheet) has a big problem with timing, since the market always makes major turns well ahead of the economics. Many times when a company comes out with good results the share price rises, sometimes it falls on good results. Sometimes, when a company brings out bad results, the share price falls and sometimes it rises on those bad results... so what's the issue? What else to look out for...Well, it's all about forward-looking expectation. And here lies the crunch! If the company produced good results that were expected by the market, the share should remain flat. If the results were good, but beat the market's expectation, then the share will rise. If, on the other hand, the results were good, but below market expectation, the share will fall. And likewise, if a company produces bad results, but they were above expectation and point to recovery, the share will rise.What we really need as far as the stock market goes, is not a whole lot of historic financial data, but rather a look forward in time. Most companies are helpful in this regard and normally have a little paragraph or so in their results report headed "future prospects", or something like that. This little section, which is most often overlooked by the fundamentalist, is the most important as far as stock market investor's are concerned.This is where the market sets its sights, not on the PE ratio or other earnings numbers. Future prospects can and do dictate how quickly (or slowly) future earnings are going to come in, so the historic PE ratio is influenced by a forward-looking factor. This affects the price side of the PE ratio as well. In other words, if the market gets a hint that the earnings are going to grow substantially in the future, it will pay up now for those earnings. This is why we sometimes see a company trading on a very high PE ratio. All it means is there's great expectation built into the price. It also means there'll be a fall in the share price if the company doesn't deliver the goods!There are so many factors relating to future expectation that come into play that we can't go into them all here. These include gearing (or debt levels), litigation, mergers and acquisitions, tax affairs, boardroom and management changes to name just a few. To illustrate how these factors affect future expectations, let’s take a closer look at gearing. This needs to be serviceable and not too unrealistic, although the market will allow for high gearing if it’s going to result in streamlined growth or better earnings in times to come (like capital expenditure, for example).Best of all, you can TRY Red Hot Penny Shares free for 1 whole month before you commit a cent on our service. Start your 1 month risk free trial now!

The past is not a guide to future performance. Trades in stocks recommended by Red Hot Penny Shares are small company shares. By their nature, such investments can be relatively illiquid and, as a result, hard to trade. This makes such shares more risky than other investments. Please seek independent financial advice if necessary. Profits from share dealing are a form of income and subject to taxation. Levels and bases of, and reliefs from, taxation are subject to change, and depend on individual circumstances.