Earnings per share is defined as net income, that we take off the

profit and loss statement, and

divide that by the average outstanding number of shares over the year.

Again, keep in mind, we've got this relationship between the flow variable,

measured over a period, and a stock variable,

measured at the end of the period.

Once we have the earnings per share, we can easily compute

the price/earnings ratio, which is defined as the market capitalization.

Number of shares,

number of outstanding shares times the share price, divided by net income.

That translates into the share price divided by the earnings per share,

the price/earnings ratio.

So, for Kellogg's in 2014, we compute the earnings per share as $632 million,

divided by 358 million shares.

That gives us $1.77 earnings per share.

When we then compute the price earning's ratio of Kellogg's for

that same end of financial year 2014, we find that the share price was

$65.58 divided by the earnings per share of $1.77 per share.

And, we find a ratio, also known as a multiple, of 37.15.

That ratio tells you that the price is 37 times earnings.

We can actually use that formula in a very quick way to compute

a forecast share price.

So, a fast track analysts price/earnings forecast is given, as follows.

We take the forecast of the price, say, at the end of 2015,

as equal to the forecast of the earnings per share over that year,

multiplied by the price/earnings ratio of the previous year.

Of course, we still need a forecast here for the earnings per share.

But, once we've got the earnings forecast, we automatically get the price

forecast, assuming that the price/earnings ratios are stable.

Because, another way of looking at this equation is that the price/earnings ratio

at the end of 2015 equals the price/earnings ratio at the end of 2014.

So, that assumes that the number of times the shareholder is willing to pay for

earnings is stable over time.

Is that really true?

What we've got here is a picture of the price/earnings ratio for

the Dow Jones Industrials over a five year period.

And, we can see that it varies wildly, so

price/earnings ratios are clearly not stable from one year to the next.

There was a clear dip in the price/earnings ratio for

the Dow Jones Industrials in the first three years of this graph,

and then it goes up to higher levels for the remaining three years of the graph.