Determining metrics

How do forward price-to-earnings ratios and dividend yields work?

- Simon Brown

I’ve been getting a lot of questions on how one determines a forward price-to-earnings ratio (P/E) or dividend yield and also how they can be used.

But let us take a step back and consider what a P/E and dividend yield are. A business exists to make a profit. Now, say a business makes a profit of R10 000 for the year. This is also called the earnings. If the business has 2 000 shares in issue, then that R10 000 profit relates to 500c per share (2 000 shares x 500c = R10 000). So, the profit or earnings per share is 500c. This is known as headline earnings per share (HEPS). If we divide this HEPS into the share price, we get the P/E ratio. If the business’ shares are trading at say R100 each, we have a P/E of 20 times. This is an indication of value in that it says 20 years of no growth earnings would equal the current share price. A company on a P/E of 10 times would require only ten years of earnings, meaning this second company would be cheaper if everything else remain the same.