Page 147 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes

Notes Decision Rules

1. Higher the P/E ratio, other things remaining the same, higher would be the value of
an equity share.
2. Lower the P/E ratio, other things remaining the same, lower would be the value of
an equity share.

Looking at the above decision rules, it is not uncommon to find that investor prefer shares of
companies higher P/E multiple.

You will appreciate that the usefulness of the above model lies in understanding the various
factors determine P/E ratio is broadly determined by:
1. Dividend payout
2. Growth

3. Risk free rate
4. Business risk
5. Financial risk
Thus, other things remaining the same
1. Higher would be the P/E ratio, if higher is the growth rate or dividend or both

2. Lower would be P/E ratio, if higher is
(a) Risk-free rate
(b) Business risk
(c) Financial risk
The foregoing presentation helps us provide a quantity measure of the value of equity share.
However, there remains the problem of estimating earning per share, which has been used in
both the methods discussed. This is a key number, which is being quoted, reported and used
most often by company management analysts, financial press etc. It is this number everybody is
attempting to forecast. The starting point to earnings per share, however, is to understand the
chemistry of earnings as described in the previous unit. We describe various approaches to
forecast earnings per share in the following sections.

4.3.7 Forecasting Earnings per Share

Things are the most important number in the arsenal of the investor. The most important and
the principal is getting information about the earnings of the company is its financial statements.
The analyst must remember the fact that there is more to the financial statements than what
meets his eyes. Out of the two statements, balance sheet and income statement, it is the income
statement that is more often used in order to gauge the future state of the firm. Research studies
have indicated the significance of this number in influencing prices and dividends. The research
study conducted by Niederhoffer and Regan for example, found that the prices are strongly
dependent on the changes in the earnings, both absolute and relative to the analysis.
The above study and some others indicate the importance of the forecast of earnings as the most
important variable to work on in the investment decision-making process. The critical aspects
of the earnings are its level, trend and stability.

142 LOVELY PROFESSIONAL UNIVERSITY