Share price indicators

In Monday's Irish Times, you publish details of the Irish Stock Exchange. Could you please explain what two of those details - "p/e" and "gross yield" - mean and how they can be interpreted?

Mr N.B., Galway

Monday's paper gives a weekly snapshot of the state of the various stocks listed on the Irish Stock Exchange. They are listed in descending order according to their market capitalisation - the overall value of the company. Market capitalisation is calculated by multiplying the value of the company's shares by the number of shares in issue at any given time.

Thus a fall in the value of the share - such as the recent temporary slump in AIB - can see that share slip down the table as the overall worth of the company falls. In the case of AIB, its slide saw Telecom Eireann briefly assume top spot in the Irish Stock Exchange as its most valuable company.

Market capitalisation is important as evidenced by the recent departure of AIB from the benchmark Dow Jones Eurostoxx 50 list. This list comprises the largest companies in the euro zone in terms of market capitalisation and it is used by institutions when they are making decisions on what stocks to invest in. AIB's departure could see its stock sold off by these institutions from their portfolios which attempt to track the performance of the Eurostoxx 50, thus leading to a lowering of its share price and overall value.

The two terms you refer too - p/e and gross yield - are other indicators of the state of companies listed on the exchange. P/e stands for "price to earnings ratio" and is a measure of a company's share price as a multiple of its earnings per share. Thus if a company has earnings per share of 36 cents - now that we are in the age of the euro on the stock exchange - and a share price of €4.50, the price/earnings ratio, or p/e, would be 12.5 (450 cents divided by 36 cents).

In reports, the company might be said to be trading on a multiple of 12.5, at 12.5 times earnings or at a p/e of 12.5. They all mean the same thing.

To calculate the earnings per share - a figure which is included by every listed company in its interim and full-year results - you simply divide the net profit by the number of shares in existence. Of course the price/earnings ratio will change every time the share price moves, often on a daily basis, but it does provide a snapshot of company performance.

If the company is on a rising price/earnings ratio, it is an indicator of a better income for the investor by way of dividends as the greater a company's earnings, the more likely it is to be able to pay more in dividend. In general, the higher the price/earnings ratio, the more likely the company is perceived as being in a growth phase. Lower p/es suggest companies where profits are more static or where it is seen as operating in a riskier sector for investors.

Turning to gross yield, this refers to the dividend paid by a company to shareholders as a percentage of the share price. Looking again at the company with a share price of €4.50 and earning per share of 36 cents. Out of these profits, company directors have to decide how much to give to the shareholders by way of dividend. Dividends provide the income for the investor from their investment.

In this case, let us assume, the board decides to give a dividend of nine cents per share - a quarter of the net profits. This is the gross dividend. To determine the gross yield, you multiply the dividend by 100 and divide by the share price - in this case 9 [X] 100 450 = 2. Therefore, the gross yield on our illustrative share is two.

The important thing to note is that you use the gross dividend in calculating the gross yield. The dividend shareholders receive and, indeed, that most often quoted in reports of company earnings in the media is the net dividend - the gross dividend less tax at the standard rate of 24 per cent. In our example, this would give a net dividend of 6.84 cents per share. If you are working from a net dividend figure on your dividend statement or in the media, you need to gross it up before working out the gross yield. To do this, you simply multiply the net dividend by 100 and divide by 76 as the net dividend is 76 per cent of number you are looking for - 6.84 [X] 100 76 = 9.

Turning to the purpose of the yield figure, it gives the investor an idea of the income they can expect to receive on the stock. Investors looking to maximise income from their holdings will opt for higher yielding shares. Investors may settle for lower yields in the expectation of growth in the years ahead or in the capital value of the shares - the growth in the share price between the point of purchase and sale.

In a low inflation environment such as we enjoy at the moment, gross yield on shares can often be better than that available in more conventional savings. However, there is always an element of risk in that the price of the shares in the market can fall as well as rise, affecting the capital value of the investment, an important part of the total return.

Like most company indicators, p/e and gross yield can be useful in comparing the performance of one company against another but they are imperfect tools. Any investor needs to look closely at the factors affecting company performance rather than simply the headline figures.

For instance, two similar companies may have widely different gross yields, apparently indicating that one is performing better than the other. However, it may simply be that Company A has decided to pay a greater proportion of its profits to shareholders in dividends than Company B. There are a number of reasons why it might want to do this and potential investors would need to look behind the figures to see what these reasons are rather than simply opting for the higher yielding share. Haste rarely makes for good investment.

Similarly in looking at price/earnings ratios, investors need to understand why a company's p/e ratio is high or low. For instance, in the Irish market recently, second-line stocks have struggled to make headway on price because the big institutional buyers are spreading their money over the wider euro zone market, leaving less local money for the smaller fry. This could skew the p/e figure. Similarly, a temporary fall in profits in a company in which investors have confidence - such as some of the technology stocks - could affect the p/e ratio.

At the end of the day, investing in stocks is a gamble but, in reducing the element of risk as far as possible, there is no substitute for research.

Please send your queries to Dominic Coyle, Q&A, The Irish Times, 11-15 D'Olier Street, Dublin 2 or e-mail to dcoyle@irish-times.ie. This column is a reader service and is not intended to replace professional advice. Due to the volume of mail, there may be a delay in answering queries. All suitable queries will be answered through the columns of the newspaper. No personal correspondence will be entered into.