But you will need to get a grasp of what the main ratios mean if you are to make the right investment decisions. This is because looking at how these different ratios compare from one company to another is an important way of judging whether their shares are good value or not and whether their share price will rise or fall.
There are a wide variety of ratios used by investors but here we have focused on the main ones you should use to sift out the best performing companies.. You can find all the figures you need to work out these ratios from the company’s annual report and accounts or if you don’t want to go to that trouble or your maths isn’t very good, you can usually find them on financial news and analysts’ websites. Read more about company accounts.
Earnings per share (EPS)
Price Earnings ratio (P/E)
PEG ratio
Return on Capital
EBITDA and EV
Current ratio and quick ratio
Dividend cover
Discounted cash flow
The Earnings per share ratio, often shortened to EPS, measures the earnings a company makes for each share in existence. 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 look not only at the current EPS but at estimates of future EPS to get an idea of the profits they will earn in future years.
The ratio you will see mentioned more than any other is the Price Earnings Ratio, which you will often see represented as PER or P/E.
The P/E 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 look not only at P/Es based on the past year’s earnings but also at 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.
If you are investing in growth companies it is worth looking at a company’s PEG ratio. This ratio, which shows a company’s P/E relative to its earnings growth rate, is worked out by taking the prospective P/E ratio and dividing this number by the prospective EPS growth. The lower the PEG ratio, the better value a company’s shares are.
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 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.
As well as checking profitability ratios you need to look at a company’s liquidity. One of the key ratios used for doing this is the current ratio. This takes the 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, you need to understand a company’s dividend cover. This ratio tells you 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. Companies, and investors, like there to be a margin of at least 1 so the dividend payout will not be affected by a short term fall in profits.
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.