This week I want to discuss financial ratios. As dull as this might sound, knowing how to calculate and use them can help you assess a company's business performance, summarise its financial status and identify relevant trends. There are many ratios in investing, but I'm going to focus on the most useful ones. However, remember that ratios are based on historical data, so they are not predictive, meaning that they should not be the only things you use to determine whether or not to purchase a stock.
The key ratio headers are profitability and solvency. After all, a company's survival is dependent upon both its profitability and an ability to generate sufficient cash to support its day-to-day operations. Profitability measures track past performance and outlook. Important concepts to know are return on capital employed (ROCE) and return on equity (ROE). ROCE is seen as the best ratio for measuring overall management performance in relation to the capital that has been paid into the business. This ratio will give you a yield percentage for the company as a whole, which you can then compare with other investments. ROE is usually found in the annual financial statements. Solvency reflects a company's debt and its net worth.
Other inportant ratios are gearing (also known as debt-to-equity), interest cover and the current ratio. These are indicators of a company's ability to service its debt. Keep in mind that interest on debt must be paid, while dividends on equity need not. So the higher the proportion of debt a company has, the higher the risk to an investor. Net asset value (NAV) is useful for assessing the minimum price at which the share should trade, and is particularly applicable to property companies and investment trusts. You can calculate the NAV by dividing net assets, less preference shares and minority interests, by ordinary shares in issue.
Earnings per share (EPS) is the amount of net profit that is available to be paid out to each share. You calculate the EPS by dividing the earnings (net profits) by the number of ordinary shares in issue. The net dividend yield gives you the total dividends paid out over a year as a percentage of the current share price. Divide the net dividend by the current share price and multiply by 100. While a high yield may appear tempting, it could signify the market's lack of confidence in a company's future ability to pay a dividend. The dividend cover is used to assess how well a company covered the payout with its profits. To reach this figure, divide the EPS by the net dividend per share. A cover of less than 1 means that the year's profits were not enough to cover the dividend.
The best known ratio is the price/earnings (P/E) ratio, or multiple. It gives investors a quick and easy way to identify shares that are either underpriced or overpriced. This is calculated by dividing the share price by the EPS. Let's say a company's stock is selling for $10 and the EPS is two; this gives us a P/E ratio of five. A high P/E suggests that a stock is overpriced. But it could also mean that investors see bright profit prospects. One thing I tell students is that they shouldn't invest in a company with no P/E ratio at all, because they have no earnings - remember all those dot.com companies? And beware of P/E ratios above 50; buying a share in one of them would be speculation, not investing.
John McGaw is a financial adviser in Dubai. Contact him at jmcgaw@emirates.net.ae
