Investing for Organizational Sustainability

wall street survivor • investing 101
6.5 EPS, PE Ratios, Cash flow per share
& ROE
We’ve discussed sales, operating income, EBITDA, and net
income. Which is the best measure of a company? The answer,
unfortunately, is none of the above.
If Stock A and Stock B are in the exact same industry, have the exact same
revenues, costs, EBITDA and net income, which is the better buy? We still
can’t answer that question until we know two more pieces of data; the
number of shares outstanding, and the share price.
Mark’s Tip!
Never, ever, ever judge a
company based on its stock
price alone.
Yahoo! and Google are both
in the online search engine
business; Yahoo! (YHOO)
trades at $20 a share and
Google (GOOG) trades at
$500 a share.
Does that mean YHOO is
cheap, and is the better
buy? Absolutely not.
You must look at the P/E
ratios of the two companies
to put their share prices
into perspective of their
earnings and number of
shares outstanding.
If you still don’t get it,
please re-read this chapter!
If Stock A and Stock B both have $5,000 of net income, but Stock A has
1,000 shares outstanding and Stock B has 100 shares outstanding, then
Stock A is earning $5 per share ($5,000/1,000 shares) and Stock B is earning
$50 per share ($5,000/100 shares). This is how earnings per share (EPS) is
calculated—the net income divided by the number of shares outstanding.
Now we can start forming expectations about a fair share price. Since
Stock A has ten times as many shares issued, then it would follow that we
would expect Stock A’s price to be one-tenth that of Stock B’s.
Fortunately, there is a common metric called the P/E, or price-to-earnings
ratio, that takes all of this into account. If Stock A is trading at $100 per
share and earning $5 per share, then its P/E is 20; if Stock B is trading at
$750 per share and earning $50 per share, then its P/E is 15. Given that
these companies are in the same industry and all else being equal, we can
conclude that Stock A is overpriced, and Stock B is underpriced.
(We are just about done with all these computations, but don’t worry —
most financial websites, including Wall Street Survivor, do the math for you.)
Assuming you understand the EPS calculation, the next obvious calculation
after EPS is cash flow per share. This is simply the cash flow from
operations divided by the number of shares outstanding. The cash flow per
share calculation eliminates the non-cash items that sometimes clutter the
income statement that don’t represent real cash outlays by the company.
Many Wall Street analysts feel cash flow per share is the best way to truly
value a company and therefore its stock.
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