In the previous posts I described how money flows in a business and what the margin of safety is. The examples I gave were simplistic and from the point of view of the business as a whole.
In this post I want to start talking about things in terms of shares/stock.
A share is fraction of the ownership of a company. If a company had 100 *shares outstanding and you owned one of them, then you would be the owner of 1% of that company.
What is the price of a share?
When the owner/s of a company wants to trade the company publicly and divide it into shares, they will have to come up with a price. The price at which the shares are going to be sold, will be set by the owners.
To do this first they come up with the business market price, this is an invented number, in the same way as you decide to sell your car or your house and you put an offer, the owners do the same. Now that the owners know how much do they want to sell their whole business for, they need to set the amount of shares outstanding it is divided in.
Example:
Market price 100.000£
Shares outstanding 10.000£
Price for 1 share 10£(Market price/Shares Outstanding)
Now that we know the share price as an investor, we are interested in the Earnings Per Share(EPS). To find this we will need to divide the Net income/Profit of the business, by the shares outstanding. The Net Income, can be found in the income statement of the company.
Example:
Net Income / Shares Outstanding = EPS
_ 20.000£ / 10.000 = 2£_
The next thing we are probably interested at as an investor is the Book value. This is the equivalent of equity(assets - liability) but at the scale of 1 share. To find the Book value of the share, we will need to take the equity from the companies balance sheet and divide it by the shares outstanding.
Example
Equity / Shares Outstanding = Book Value
7.000£ / 10.000 = 0.7£
So using the Shares Outstanding we calculated the EPS and the Book Value, this two parameters are key for calculating the P/E ratio.
P/E ratio, stand for Price to Earnings, it is a very valuable information for the investor for getting an idea of what his returns will be like in the future.
This is how it works; To calculate the P/E ratio, just divide the Market Price of 1 share, by the EPS
Example
Market Price 1 share / EPS = P/E ratio
10£ / 2£ = 5£
How does the P/E ratio help us?
Now that we calculated the P/E ratio, we can understand it easier with the following sentence:
For every 5£(P/E) I invest in this stock I will receive 1£ in profit next year.
Remember: THE GREATER THE P/E RATIO THE SMALLER THE PROFIT
*shares outstanding: The total amount of shares into which a company is divided.
