One of the typical valuation tools used by investors is the price earnings ratio. Price earnings ratio is calculated by dividing stock price over earnings.
Just as there are different investors, there are many ways that this otherwise seemingly simple indicator is calculated. Price is usually easily accessible in our information age, and it is typically the easiest input to be obtained online. Earnings per share is an indicator which often requires a little bit of additional research before applying in the equation. One of the first questions that investors need to ask themselves before looking at P/E ratios is to gain an understanding of the denominator in the equation.
I typically focus on earnings from continuing operations. I tend to exclude one-time accounting items such as goodwill impairment charges for example. The reason is that I focus on earnings stream that the company will generate from recurring operations. The fact that the company overpaid for a subsidiary five years ago is irrelevant for my investing decision, as long as this does not affect earnings from continuing operation. As a result, by normalizing earnings per share (EPS), I sometimes arrive at different P/E ratio figures than what you might usually see on Yahoo! Finance for example. Johnson & Johnson (JNJ) is a great case in point. While Yahoo Finance shows EPS of $3.86, my analysis calculated EPS to be $4.89/share.
Another question that investors should ask themselves is whether earnings per share are sustainable. I usually prefer to focus on companies that have the potential to grow earnings over time. A company with low P/E ratio could look undervalued. If analysts expect EPS to drop 50% however, and remain low, then it could end up being a value trap for investors. Apple (AAPL) currently trades at ten times earnings. However, this reflects the overall bearishness on the company's ability to maintain profits going forward, given the intensely competitive nature of the smartphone market. Sales of smartphones have accounted for a large part of Apple's growth over the past five years. Competition from Samsung, LG, and HTC has eroded Apple's market share.
If earnings per share are not steadily increasing over time, this could mean stock prices and dividends per share cannot sustainably grow. Investors should be advised to avoid such enterprises, as their dividend income is likely to remain stagnant. They would be much better off in fixed income, since they have a better chance of recovering principal.
One case in point is Intel Corporation (INTC). Over the past five years this tech juggernaut has suffered from low EPS growth. This has been caused by slowing sales in traditional computing devices. The company needs to expand presence in mobile devices chips. Thus shares appear undervalued, but without growth in earnings, investors returns are limited to the current yield. If earnings per share decline, the dividend payout ratio might become unsustainably high, and dividends might be cut. Either way, without earnings growth, future dividend growth will be limited. In addition, if Intel decides to spend more in R&D or buy its way in the market for mobile device chips, management might even decide to sacrifice the high dividend payments.
Disclosure: I am long JNJ.