P/E (Price to earnings Ratio) is one of the important statistic that we usually look at to measure how attractive the valuation of the stock currently is. This ratio indicates the A valuation of a company’s current share price compared to its per-share earnings. Hence it indicates how the company has progressed its earnings in the past years, and it is extrapolated to get the future earnings too. Buying shares having too high P/E is not acceptable at any cause. If P/E has such high importance among the investors, do you think the real per-share earning can be obtained so easily? Lets see here how the big owners of the companies can manipulated this vital P/E ratio, so as to make the stock look attractive than it actually is.
1. The company may show a big sizable number as per-share earning, but in the foot note it may take away a major part of it as special charges and there by reducing per-share earning. Sometimes the special charges may not be really so special, and it may show all its operating expenses and even losses as special charges.
2. Check whether the per-share earning you are taking for valuation is fully diluted. The company may have other convertibles which public generally convert if the situation is friendly. At any condition, you should only take the diluted earnings. Also if possible, check whether the company has any plans to dilute further, which may take away your piece of pie.
3. “Anticipated losses” which sometimes occurs in the foot notes whispers that in the coming financial year, the company expects losses. The company however may not show those losses when it really occurs, as it has already accounted for those losses. This may project a worst year for the company as not so worse one. Moreover, the tax savings they obtained do to the losses (the one anticipated) may enter the next years accounts as a part of net-income
4. Depreciation has always been a very big opportunity where the officials may give their prestidigitatory hand a handsome work. Consider that you have bought a computer for Rs.25K. In the first 2 or 3 years, the computer loses all its value, and hence after that period, there depreciated amount is very less. What I mean is, depreciation is always not the same, and there are very complicated and unique ways of calculation. I will be writing a separate article on depreciation alone very soon. Just check whether the company has changed its way of accounting depreciation. And sometimes changes in the depreciation accounting may defer income tax payments too.
5. Company also has the choice to either show the full charges of R&D in the current year, or it can amortize it to may years.
6. The company generally projects “pro forma” earnings, which shows you the profit the company would have made in case some bad/extrordinary event didn’t happen. Consider the case of the attack on hotel Taj few months back. It would have surely affected its current earnings, but long term scenario remaining the same. Using Pro forma in those cases makes absolute sense to get an over all long term pictuer. But there are companies which excludes preferred stock dividends, taxes paid, bad investments, etc, and shows a very attractive pro forma earning. Hence in general, its always better to forget about the pro forma earnings as more companies have come to misuse it, than guiding the stock holders.
7. Change in accounting principles all of a sudden must be a sign of causion. Will a company change its accounting principles unless the new principles helps to project itself in a better way?
8. The company’s operating expenditure may go in as capital expences thereby showing a better figure for the net income. This will increase the net assets of the company (the operating expences has become net assets in this case)
9. The company can devaluate its inventories (and show it as special events), so as to show that there is no accumulation of inventories year after year.
10. Assumption of Unreasonable interest rate from the pention funds, and can expect a great return from that itself. Check how other companies expect the interest rate to be, and make conclusions.
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