Understanding variation among ratios

You'll probably find varying P/E ratios for the same company because the number used for EPS can vary depending on which method for calculating EPS the company chooses. The diluted EPS is the one you should generally use. This figure is based on the current number of shares on the market, as well as those promised to employees for purchase in the future and those promised to creditors that may decide to convert a debt into a stockholding (if that's part of the debt agreement). So diluted earnings gives you the most accurate picture of the actual earnings per share of stock now available on the market or committed for sale in the future.

But when companies put out a press release, they tend to use whatever EPS looks most favorable for them. Companies can choose among four basic ways to calculate EPS:

✓ Reported EPS: Companies calculate this EPS number by using general accounting principles and report it on the financial statements. They show it in two formats: basic and diluted. Most times, the diluted EPS number is the best one to use, but sometimes it can be distorted by one-time events, such as the sale of a division or a one-time charge for discontinued operations. So you need to read the notes to the financial statements to determine whether the EPS figure needs to be adjusted for unusual events. Chapter 9 discusses the notes to the financial statements in great detail.

✓ Pro forma EPS: You almost always find this EPS in a company's press release because it makes the company look the best. In most cases, this figure excludes some of the expenses or income the firm uses in the official financial reports. The company adjusts these official numbers to take out income that won't recur, such as a one-time gain on the sale of marketable securities, or expenses that won't recur, such as the closing of a large division.

When a company mentions Pro forma EPS or statements in its press release, be sure that you compare these numbers with what the company develops using generally accepted accounting principles (GAAP) and reports in the financial statements filed with the Securities and Exchange Commission (SEC).

✓ Headline EPS: This EPS is the one you hear about on TV and read about in the newspapers. The earnings per share numbers used may be basic EPS, diluted EPS, Pro forma EPS, or some other EPS calculated based on analysts' projections, so you have absolutely no idea what's behind the numbers or the P/E ratio calculated using it. It's likely the most unreliable EPS, and you shouldn't use it for your evaluation.

✓ Cash EPS: Companies calculate this EPS by using operating cash flow (cash generated by business operations to produce and sell its products). Operating cash can't be manipulated by accounting rules as easily as net income, so some analysts believe this EPS is the purest. When you see this number, be sure it's based on operating cash and isn't just a fancy way of saying EBITDA (earnings before interest, taxes, depreciation, and amortization). You can judge this by calculating the Cash EPS using the EBITDA reported on the financial statements and the net cash from operations reported on the statement of cash flows. Only the net cash figure gives you a true picture of cash flow.

The P/E ratio is an ever-changing number based on the day's market price. It's also a number that's hard to depend on unless you know the calculations behind it. Companies can calculate the earnings per share in many different ways — using basic EPS, diluted EPS, Pro forma EPS, cash EPS, headline EPS, and projected or leading EPS. Reading the financial reports and checking the calculation for yourself is the only way that you can truly determine a company's P/E and what's included in its calculation.

The Dividend Payout Ratio

The dividend payout ratio looks at the amount of a firm's earnings that it pays out to investors. Using this ratio, you can determine the actual cash return you'll get by buying and holding a share of stock.

Some companies pay a portion of their earnings directly to their shareholders using dividends. Growth companies, which reinvest all their profits, rarely pay out dividends, but older, mature companies usually do. Older companies that no longer need to reinvest large sums in growing their businesses pay out the highest dividends.

To determine how well investors did with their stock holding, you can calculate the dividend payout ratio.

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