On reflection after my last post; one thing I realised I perhaps shouldn’t be doing, is making up the numbers so I can benefit from a lower charge the next month (you need to read my last post to understand what I’m talking about).
Think about this; for each deal, there’s a fee of £11. Imagine that I invest in 4 shares that are really of interest to me (fee = £44) and then I invest in another five (fee=£55) just to make up the numbers. The extra £55 paid in fees, I probably could have invested in at least one other share in one of the companies I am interested in. Anyway, it’s done now and I am reflecting and learning, which is all part of the journey.
So on to the focus of this week’s post; I had promised to share some of my knowledge on investor ratios and how I might use them to make decisions on which shares to sell and which to hold. There are however several ratios, so I have limited this to some which I think are critical to an investment decision.
I found some pictures on Instagram that tells you how to calculate the ratios (remember that you won’t need to do this as the information would be available within financial section of your investment platform or on the company’s website or on google) and I have provided explanations of what each of the ratios mean and what the consideration should be when using them in making investment decision.
Earnings Per Share (EPS) – This ratio tells you about the profitability of a company. It tells you how much of earnings (i.e. profit after tax) a company is generating for each of its shares e.g. if a company’s earnings for the year is £50,000 and it has 25,000 shares in issue, it means the company has generated £2 profit for each share in issue. If you hold 100 shares, that would mean the company has generated £200 worth of profit for your shares. So the higher the EPS, the more attractive a company’s share would be for investors.
Price Earnings Ratio (PER) – this is an investment ratio that tells you how much you would you would need to have invested in a company in order to be entitled to a portion of its earnings e.g. if a company’s EPS is £2 and its share is selling at £30, its PER would be 15, if the EPS for the same company was £5, its PER will would be 6. A high PER implies that people are paying a high price for a company’s share compared to the company’s earnings; this could be an indication of trust/confidence in a brand that investment would yield high profits in future or because of future plans of the company, or it could simply be that the shares are overvalued. Investors are likely to receive more earnings by investing in companies with lower PER, but on the flip side, a low PER could be an indication of a lack of confidence in a company’s prospects.
Return on Equity (ROE) – this ratio tells you about the performance of a company. It tells you how efficiently a company is utilising its shareholders investments, to generate profits. The higher this ratio, the higher earnings are likely to be and the higher the share price as well (as the high earnings will drive investors interest and the higher the demand the higher the price will become) and of course, the higher this ratio the better.
Price to Book Ratio (PBR) – this ratio basically compares what the market value of a share to its book value. Though this ratio doesn’t provide any information about a company’s ability to generate profit or returns for shareholders, it is useful for determining whether a share is under-valued (and in turn a potential gold mine for an investor who invests in the share early enough) or whether it is overvalued. This ratio is however best used to assess asset based companies, rather than service or intellectual property companies. So if you are investing for capital growth, this ratio could be useful in deciding which shares to invest in.
Dividend Yield: tells you how much a company pays out in dividend each year, relative to its share price. It is an indication of how much future income an investor could generate from the shares they hold, given current share price. This is an important ratio for dividend investors.
Debt –Equity ratio: This is a leverage ratio that indicates the proportion of a company’s debt in comparison to its equity and is an indication of the proportion of a company’s operations that is being financed by debt and whether a company possesses sufficient equity to cover its debt. While equity being able to cover debt might not be too important during good times, in times like we are now (a downturn) a company’s survival could be dependent on whether it is able to cover its debts from its equity. Therefore, investing in a highly leveraged company, could be risky. However companies generally utilise debt as it is cheaper (up to a certain point) and rather than organic growth, it provides the opportunity to aggressively pursue growth. Provided utilising debt results in earnings that are higher than the cost of the debt and the economy is not in a downturn, then a high debt-equity ratio shouldn’t be a cause for alarm.
An important point to note is that the ratios should not be used in isolation, for making investment decisions, rather comparisons need to done.
- Comparison between current year’s ratios and previous years’ – have the ratios been growing or falling, what future plans does the company have and what developments are there in its external environment that might influence its earnings and share price.
- Comparison with similar companies in it sector
- Comparison with sector average.
Non-financial considerations are also important and could include things like;
- Reliability of the company to follow through on future plans (e.g. has the company’s previous plans always been delivered on or not and can investors rely on what it says it will deliver now e.g. a company whose annual report has over the years indicated a plan to produce a green washing machine, but 3 years on haven’t even made a start will not generate confidence when they say they have another big plan which might impact their profitability and make its share attractive to an investor),
- The company management – how experienced and skilled are they in managing and generating a return for companies, what are they doing e.g. dumping all their shares in the company they manage
- The company culture and ethos – what’s the company doing in regards improving the environment, how ethical is the company, is it an equal-opportunities employer, etc.
Overall, what the figures and ratios tell you, are a starting point, non-financial considerations are also important.
In reality, investment decisions are personal e.g. one person might be more interested in value shares and another in dividend shares and similarly, how much weight is attached to a company’s being ethical or environmentally friendly, will differ from person to person, so it is important that you do your own research and make decisions based on both the financial and non-financial considerations that align with your values and risk appetite.
I hope you find some value in this post. I really enjoyed writing it as well and will also enjoy reading your comments about it; including any additional considerations you think should be made when investing.
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📝 Originally shared under my first blog, bitalks; part of the journey that shaped Life’s Riches.