1. Dividend. Earnings per share ratio. Price -to-earnings ratio or P/E ratio
As far as a way of benefitting shareholders is concerned, companies have legal instrument to do it. They allot a part of their profits for a dividend and pay it out among shareholders. Benefit from owing shares should have not differ from profits offered by banks for deposits. Unfortunately, that is not the case. In many cases not only yearly dividend but also/even(?) net profit falling to a share (in stock market terminology called “earnings per share”, in short EPS) is significantly lower than interest on bank deposits paid for an equivalent of a share in money.
In order to find an explanation for this phenomenon let us follow through some underlying aspects of the stock market. For that purpose we will scrutinize the other indicator, converse of EPS, called the P/E ratio (price-to-earnings ratio). It is in everyday use for its simplicity and easiness of comprehension for an average people.
As reads Investopedia: ”The P/E ratio is a measure of the price paid for a share relative to the annual net income (profit) earned by the company per share”.[1] In turn, Investorwords explains it as follows:
The P/E ratio is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period, usually the current period. The value is the same whether the calculation is done for the whole company or on a per-share basis.[2]
To put it simply, the indicator shows investors how long (in years) it will take before they can recover their investment (ignoring the time value of money). P/E changes constantly along with a share price fluctuations. Rising price makes it lower and going down higher. Consequently, a current level of P/E ratio should theoretically tell us whether a particular share is cheap or expensive. As a matter of fact, companies with high P/E ratios are more likely to be considered "risky" investments than those with low P/E ratios.
2. High P/E or low P/E. Some aspects of companies’ profitability.
Is this really so? Not necessarily. For example, P/E = 76, which Google exceeded with the price of $100 during the summer of 2005[3], informed that the company generates an average yearly profit meager 1,5%. Whence it followed that the price of shares was on an extremely high level and investment in the company was considered a very risky venture. On the other side, one of the world's largest tobacco corporation Altria Group, Inc. (until January 2003 named Philip Morris Companies Inc.), in 2005 with the price of shares $65[4] had P/E = 13,7, offering seemingly very encouraging 7,3% yearly return from investment.[5] It is necessary to mention, that the benchmark federal funds interest rates in USA was then 2,5% and yield for savings accounts offered by banks hovered between 1,5- 2,4%.[6] Simultaneously, the alternative investment, short term US Treasuries, in May 2005 stood at 2,5%.[7] To sum up, the stock market visibly perceived one business as better than the other. What is a reason of such a situation?
There is one more factor, that have not been taken yet into our consideration – prospects for a company. Paying allegedly exorbitant price for Google people expressed their belief as to the sustained development of possibilities that presented Internet. On the other side, Altria was operating in the area that was not getting a sympathetic response and its prospects seemed to be bleak. After years of researches it was proved that smoking cigarettes was connected to numerous diseases and had a number of short and long term effects on health. Soon victims of lung and throat cancer or their family started suing the company to the court. As the effect of lost trials, until 2010 Altria spent hundreds of millions of dollars for damages.
In January 2011 shares of Google cost over $600, i.e. three times more than in June 2005,[8] whereas Altria within the same period of time lost more than a half of its value, falling to $24.5.[9] After five years it turned out that predicting future of a company is of utmost importance and being prone to risky investment often pays off.
Generally, it is undeniable that future of a company has to be factored in while choosing shares to buy, but it is nevertheless true that this reason cannot be the only one. As a proof against it let us to look at another Internet company, Amazon.com.
The company was founded in 1994 in Seattle, Washington, as a bookstore. In 1997 it made its debut on Nasdaq with the price $1,5 and a long time did not attract anyone’s attention. But soon investors perceived incredible prospects for the Internet. The price of shares of Amazon started to balloon. A year later it was about $20, two years later gained to $60 only to cross $100 in December 1999. Then the shares began their sudden reversal. Until September 17, 2001 they fell to $7,5, bringing investors loss of 93%. It took the next 8 years for them to return to the previous maximum level what happened July 13, 2009.[10]
[1] http://www.investorwords.com/3656/P_E_ratio.html
[2] http://www.investorwords.com/3656/P_E_ratio.html
[3] http://finance.yahoo.com/echarts?s=GOOG+Interactive#symbol=GOOG;range=my
[4]http://finance.yahoo.com/echarts?s=MO+Interactive#chart2:symbol=mo;range=my;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined
[5] http://www.stock-analysis-on.net/NYSE/Company/Altria-Group-Inc/Valuation/Ratios#PE
[6]http://banking.about.com/od/savings/a/savingsrates.htm
[7] http://www.treasurydirect.gov/indiv/research/indepth/ebonds/res_e_marketbonds.htm
[8]http://finance.yahoo.com/echarts?s=GOOG+Interactive#chart2:symbol=goog;range=ytd;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined
[9]http://finance.yahoo.com/echarts?s=MO+Interactive#chart1:symbol=mo;range=6m;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined
[10] http://finance.yahoo.com/q/pr?s=AMZN+Profile
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