Processing Knowledge

A few days back I received a list of stocks that are currently having a negative enterprise value (EV) but a good forward earnings per share (EPS or P/E). I was a bit confused by this jargon and wanted to know what is the actual meaning of these terms. I came across this good post by a KPO regarding negative EV and why they are a good investment opportunity, however I was not sure about forward EPS as I was only aware of P/E, i.e., the price per earning.

The Price to Earning Ratio (P/E )

The price earning ratio is, as the name suggests, P/E where P = Price Per Share and E is the annual Earnings per share. Thus, as the units of P/E is the number of years, the P/E ratio is a nice indicator of the number of years of earnings that are required to get the purchase price of the stock. The component P is the value of the stock price while buying the stock however financial analysts such as S.G Analytics have various ways of computing E. The traditional value of E is computed as the earnings per share for the recent 12 months period.
For e.g. if the stock price of a company is $10 and the earnings (dividends) over the recent 12 month period is $1, then the P/E = 10/1 = 10 years.

How to identify companies that performed badly last year but have good prospects this year?

The P/E is a good indication of the past performance of the company however given the current economic scenario it is not a good indicator of which stocks have a potential to perform well. There are metrics like the T-Model, that take into account the growth rate but computing such metrics is better left to the financial analysts and fund managers. However a simple metric that can take into account the growth is by using the potential earnings per share given the growth potential of the sector. This is exactly what is done while computing the forward EPS. In case of forward EPS, the expected earnings per share is the E in the P/E ratio. Thus, the forward EPS is many a times referred to as the estimated price to earnings by financial analysts.

A word of caution

Over the years a stock’s P/E is used as a good indication of how much investors are willing to pay per dollar of earnings. As the P/E takes into account the earnings per share it gives a much better indicator of a stock’s value than the market price alone. However, there are many reasons for a forward EPS to be high/low which are many a times heavily dependent on the market sentiments.