Understanding Investment RatiosBy CCTrader - April 13, 2016 |
Investors will come across a wide variety of financial ratios when reading reports that concern companies listed on a stock exchange. At first, these ratios can seem complicated to those new to stock market investing but it is important to understand what the main ratios mean to be able to gauge a company and make the right investment decisions. By analysing how these different ratios compare from one company to another, an investor can judge whether the shares in a particular company are good value or not.
There are a wide variety of ratios used by investors that you can use to pick the best performing companies. The figures needed to work out these ratios can be found in the company’s annual report and accounts or better still you can usually find the ratios ready worked out on financial news websites.
Earnings Per Share (EPS)
The Earnings per share ratio, measures the earnings a company makes for each share issued. It is calculated by taking a company’s net earnings and dividing them by the number of shares in issue.
A higher EPS is regarded as better than a low EPS as it means investors are earning bigger profits for every share they own. Investors can also look at the estimates of future EPS to get an idea of the profits they will earn in future years.
Price Earnings Ratio (P/E)
A widely used ratio is the Price Earnings Ratio which measures whether a company is cheap or expensive. It is calculated by dividing a company’s share price by its earnings per share (profits after tax divided by the number of shares in issue). As a rule, the higher the P/E, the faster its earnings are growing but if the P/E is high compared with other companies in the same sector, it could also mean the shares are overvalued.
This ratio enables any business to be compared with another, although in reality investors tend to compare companies against those in the same industry sector or against the P/E on the entire market.
Investors can also look at analysts estimates of future P/Es, also known as prospective P/Es. This gives investors an idea as to how fast a company’s earnings are expected to grow in the future and, therefore, whether their shares are worth buying or not.
Return on Capital
This ratio helps investors assess how hard a company is making its assets work. It is calculated by taking profits before interest and tax are removed and dividing this figure by the capital employed. Broadly speaking, the higher the return on capital, the more successful a company is.
EBITDA and EV
EBITDA is a profit key ratio that looks at the Earnings Before Interest, Tax, Depreciation and Amortisation. It is used to assess the operative profitability of a company. You can use this ratio to analyse companies that reinvest heavily in their businesses by taking the Enterprise Value and dividing it by EBITDA.
Current ratio and quick ratio
As well as checking profitability ratios investors should also look at a company’s liquidity. One of the key ratios used for this is the current ratio. This is calculated by taking the total current assets and divides it by the firm’s current liabilities.
You should also look at the quick ratio, also known as the ‘acid test’. It is known as the quick ratio because it gives you a quick grasp of a company’s true liquidity. You work it out by taking the current assets and deducting stock and work in progress and then dividing this figure by the current liabilities. As a rule this ratio should be over 1 so that if a company’s stocks were worthless it could still pay off its short term debts.
If you are investing in a company that pays dividends, it is important to understand a company’s dividend cover. This ratio shows if a company will be able to pay its dividend. It is worked out by looking at the margin by which the dividends paid to shareholders are exceeded by the company’s earnings per share. Generally a company should have a margin of at least 1 so the dividend payout will not be affected by a short term fall in profits. However investors should keep in mind that not all companies have a policy of paying dividends as these are used to grow the company, a typical example is Apple Inc.
Discounted Cash Flow
The discounted cash flow evaluates the future net cash flows and discounts them to their present day value. This ratio has become increasingly popular among investors since the bear market started in 2000 as it looks at the amount of cash available on a company’s balance sheet. The more cash a company has available, the better it is able to protect itself through difficult economic times.