Define Growth in Earnings

Growth in Earnings

Further, the growth in earnings also influences the value of the stock. The growth in earnings depends on the earnings retained and reinvested in the firm.

The rate of return on equity also influences the growth rate Growth rate = Retention rate x Return on equity = RR x ROE

The same can be rewritten as follows:

Substituting and rearranging we get

This analysis is known as DuPont analysis because it was popularized by DuPont Company.

Price Earnings Ratio

One of the most common financial parameters used in the stock market is the price-earnings ratio (P/E). it relates the share price with earnings per share. Most of the news papers along with the stock price quotations give the P/E ratio too. The P/E ratio is the multiplying factor that the market is willing to offer to the company’s future earnings. In the “A” company’s earnings per share is ` 6 and price ` 50, then: 

The P/E of 8.33 means that the market is prepared to pay ` 8.33 for every rupee of future earnings. The past performance is the base for the estimate. High P/E ratio indicates high expectation of the market regarding the growth of future earnings of the company. The P/E ratio has links with other financial parameters like dividend payout, dividend growth rates and low cost of funds will result in high P/E ratios.

The investors generally compare the P/E ratio of the company with that of the industry and market. A P/E ratio lower than industry means that the stock is underpriced. Investors should be careful n comparing the scrip’s P/E with the industry’s P/E because sometimes, the industry P/E may be high due to overheated market. In such a situation, the industry’s P/E should be moderated to acceptable levels. The investor can also forecast the future P/E ratio and compare it with the present P/E to assess the extent of under pricing of the particular share. Forecast can be done by studying fundamental factors and applying statistical techniques using past P/E data. The comparison of the estimated P/E ratio with the actual P/E ratio leads to one of these three conclusions given below:

If the current P/E ratio is larger than the E (P/E) ratio, the stock is overpriced. It is better to sell the shares before the fall in price.

If the current P/E ratio is smaller than the E (P/E) ratio, the stock is underpriced and it could be a best buy with the expectation of the rise in price.

If the current P/E ratio equals the E(P/E) ratio, the stock is correctly priced. No significant changes in prices are likely to occur.

Intrinsic Value

The true economic worth of the share is its intrinsic value. The fundamental analysis find out the intrinsic value of a share of using the following formula:

Intrinsic value of a share = normalized EPS x Expected P/E ratio The expected P/E ratio can be found out by

The numerator is:

Payout ratio = Cash dividend per share / Expected earnings per share = D/E (EPS)

To forecast the P/E, the analyst should have the following details:

Stock’risk – adjusted discount rat

Growth rate (g)

Cash dividend per share (D)

Earnings per share (EPS)

Pay out ratio (D/E)

The simple technique adopted by the analyst is as follows:

Intrinsic value = Average P/E ratio over the years x Present earnings per share OR

Pp Average P/BV ratio over the years x Present book value per share This calculation is based on the assumptions that

The trend in the profitability of the immediate past and the present will continue to be the same.

The average P/E, P/BV and average earnings to equity ratio remain constant over a period of time.