Balance of payments

It used to be that the investment measure known as the price/earnings ratio, normally referred to only as the 'PE', was the guiding benchmark of investment valuation. You bought stocks that had low PE ratios and shunned those with high PE ratios, except of course if those high PE stocks also showed stellar earnings growth.

Except, except, except. This is exactly what happened to the PE ratio. There are too many exceptions. It does not make a good benchmark all on its own. It is why investment analysts look for other definitions of earnings or returns on investment. The PE ratio gives you only a broad-brush picture, and even then can be distorted.

Start with the difficulty that when considering whether to buy a stock you cannot use the overall net profit of a company for the PE ratio. You are not buying an entire company. You are buying shares in a company. You therefore need to calculate what the earnings per share of the company are. This requires that you have a figure for share capital so that you can divide the profit by the number of shares in issue.

It seems straightforward, but it isn't. We shall do this simply. Take, for example, Company A, which in Year 1 has 100 shares in issue and makes a net profit of $100. We shall thus make its earnings per share $1.

Now assume that on Day 1 of Year 2 Company A buys Company B and pays for it by issuing 100 new shares. We now have 200 shares in issue but, because Company B is just as good at its business as Company A, it also makes a net profit of $100 in the year. At the end of the year the enlarged Company A has $200 profit for 200 shares in issue. The earnings per share therefore remain $1.

But now let's take the case where Company A buys Company B on the last day of Year 2 and pays for it in the same way by issuing 100 new shares. We now have something different. Company B's earnings for 364 of the 365 days in that year are attributable to its original owners. Company A does not get that money.