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Understanding investment ratios

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Understanding investment ratios

  • Widely used in financial analysis, ratios can be great tools when it comes to making decisions about companies you would like to invest.
  • Investment ratios can be calculated using data found in various financial statements like balance sheets and income statements, whereby a specific variable is divided from another.
  • To analyse a company’s profitability, the Earnings Per Share ratio (EPS) measures the earnings a company makes for each share issued. 
  • The Price Earnings Ratio (P/E) evaluates whether a company is cheap or expensive, while it reflects investors’ assessments of future earnings.
  • If you would like to analyse a company’s financials for profitability performance purposes, the return on Capital Employed or ROCE ratio is applied which measures an organisation’s profitability in terms of all of its capital.
  • On the other hand, the EV/EBITDA helps determine the fair market value of a company by looking at the Earnings Before Interest, Tax, Depreciation and Amortisation. It is used to assess the operative profitability of a company, as well as its cash flow.
  • Both the current and the quick ratio measure a company’s financial health by looking at its short-term liquidity, however, the current ratio evaluates its ability to pay current or short-term liabilities with its current or short-term assets, whereas the quick ratio gauges how its current assets could potentially cover its liabilities.
  • If you are investing in a company that pays dividends, it is important to understand a company’s dividend cover. The Dividend Cover Ratio determines if a company will be able to pay its dividend.  
  • The Discounted Cash Flow (DCF) identifies the value of a business or a security and evaluates the future net cash flows and discounts them to their present-day value. The formula is often used to value an entire business, as well as to value instruments and other investments.
  • Are investment ratios too confusing for you to calculate and apply in practice? Our experienced investment advisors can simplify the complex for you. Get in touch with us today to explore further how we can help you achieve your financial objectives with our wide range of investment products and by applying the appropriate investment ratios. 

 

You read financial reports and prospectuses and go through various number and jargon-filled analyses to research potential investments. But how can you boil all this raw data down into usable information to make sound investment decisions? With the help of investment ratios. 

Investors will come across a wide variety of financial ratios when reading reports that involve companies listed on a stock exchange. At first, these can seem complicated to stock market investing novices but it is important to understand what the main ratios mean so as to be able to gauge a company and make the right investment decisions. In this manner, you will be able to pick the best performing companies, while you will be better equipped to judge whether the shares are good value or not.

Read along to find out how ratios can give you an edge in your investing.

 

So what are investment ratios and what do they do?

Widely used in financial analysis, ratios can be great tools when it comes to making decisions about companies you would like to invest in. Forming the very basis of fundamental analysis, they are used across the industry by individual investors, as well as professional analysts to understand how companies are doing internally and compared to one another, while they can greatly influence investment decisions.
Ratios can be calculated using data found in various financial statements such as balance sheets and income statements, whereby these calculations involve dividing one variable from another. Once you have all the data available, you can input these into your financial analysis tools and put those numbers to work for you. And although they cannot, for instance, automate your stock-picking decisions, ratios can afford you with greater confidence in your investment decisions and may potentially help you avoid large losses.

 

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Earnings Per Share (EPS)

The Earnings Per Share ratio measures the earnings a company makes for each share issued and it is calculated by taking a company’s net earnings and dividing it by the number of shares in issue. The ensuing number serves as an indicator of a company’s profitability. One of the most widely quoted figures by analysts, stockholders and potential investors alike, the EPS metric is also important when it comes to calculating the Price Earnings Ratio (P/E), where the E in the P/E refers to the EPS. As a result, this ratio could be used to determine whether you should select particular stocks.

As expected, if a company has zero or negative earnings which indicate a loss, then likewise, earnings per share will also be zero or negative. In contrast, a higher EPS means investors are earning bigger profits for every share they own. At the same time, a high EPS figure is a clear sign of a company’s strong financial position and this means that it is a reliable organisation. In addition, investors can also look at the estimates of a future EPS to get an idea of the profits they will earn in the years to come.

 

Price Earnings Ratio (P/E)

A widely used ratio is the Price Earnings Ratio which measures whether a company is cheap or expensive, while it reflects investors’ assessments of future earnings. It is calculated by dividing an organisation’s share price by its earnings per share (profits after tax divided by the number of shares in issue).

In addition, two kinds of P/E ratios are used, the trailing and the forward P/E. With the former, the P/E carries the notation ‘TTM’, a Wall Street acronym for ‘trailing 12 months’ which signals the company’s performance over the past 12 months. Bearing in mind that a company has reported its earnings accurately, then the trailing P/E is considered the most objective P/E metric. With the later, the P/E metric uses future earnings guidance or a forward-looking indicator for comparing current earnings with future ones.

As a general rule of thumb, the higher the P/E, the faster its earnings are growing, however, if the P/E is high compared with that of other companies in the same sector, this could possibly be an indication that the shares are overvalued. Having said that, a high P/E ratio could also reflect investors’ expectations for high growth rates in the future. On the other hand, companies that have no earning or those that are losing money do not have a P/E ratio since there is nothing to put in the denominator.

Investors can also look at analysts’ estimates of future P/Es, also known as prospective P/Es, which gives them 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 Employed (ROCE)

One of the many profitability ratios available, the ROCE measures an organisation’s profitability in terms of all of its capital. In other words, it can prove the value the business gains from its assets and liabilities. Calculated by dividing earnings before interest and tax (EBIT) by the capital employed, when ROCE is higher than the cost of capital, then it is considered that the company has used the capital in an efficient manner to generate profits. In effect, companies that achieve an ever-increasing ROCE over the years serve as a clear indication that they are stable businesses and an attractive investment option for investors.

 

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EBITDA and EV

One of the most widely used valuation multiples based on enterprise value (EV), often employed either in conjunction with or as an alternative to the P/E ratio, the EV/EBITDA helps to determine the fair market value of a company. More specifically, 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, as well as its cash flow.
To calculate the EBITDA margin the earnings are divided by revenue and the resultant number is the company’s operating profitability. The EV is the numerator in the EV/EBITDA ratio and it is equal to a company’s equity value or market capitalisation, plus its debt or any financial commitments, less any cash.

You can use this ratio to analyse companies that reinvest heavily in their businesses by taking the Enterprise Value and dividing it by EBITDA. In addition, EV/EBITDA may also be used during negotiations for the acquisition of a private business or for instance, in calculating a target price for a company in an equity research report.

 

Current ratio and quick ratio

Both the current and the quick ratio measure a company’s financial health by looking at its short-term liquidity, however, there are differences between the two. One of the key ratios used for evaluating a company’s liquidity is the current ratio. This is calculated by taking the total current assets and divides it by the firm’s current liabilities. It essentially measures a company’s ability to pay current or short-term liabilities like debt and payables with its current or short-term assets such as cash and inventory.

On the other hand, the quick ratio, also known as the ‘acid test’ is an indicator of a company’s short-term liquidity position and evaluates how its current assets could potentially cover its liabilities. It is known as the quick ratio because it offers a quick grasp of a company’s true liquidity. You can work this ratio out by taking the current assets and deducting stock and work in progress and then dividing this figure by the current liabilities. As a general rule of thumb, this ratio should be over 1 so that if a company’s stocks were worthless, it could still pay off its short-term debts.

 

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Dividend Cover Ratio (DCR)

If you are investing in a company that pays dividends, it is important to understand a its dividend cover. This ratio is worked out by looking at the margin by which the dividends paid to shareholders are exceeded by the company’s earnings per share. More specifically, the DCR ratio can be calculated by dividing the net income available to common stockholders by the number of dividends paid. The net income is the earnings after all expenses including taxes are paid, whereas dividend declared is the amount of dividend entitled to shareholders.

Generally speaking, 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. Also, a low dividend cover means that an organisation will not be able to pay the same level of dividends in a bad year’s trading, while a negative dividend cover is a clear sign that the company is in trouble.

 

Discounted Cash Flow (DCF)

Employed to determine the value of a business or a security, the discounted cash flow evaluates the future net cash flows and discounts them to their present-day value. At the same time, it is useful for both investors looking to make an investment and business owners who would like to make changes to their organisation. The formula is often used to value an entire company, to value anything that has an impact on cash flow, as well as to value instruments like bonds, shares and other investments. The more cash a company has available, the better it is able to protect itself through difficult economic times.

To find the present value of expected future cash flows, DCF uses a discount rate, while companies typically make use of what is known as the weighted average cost of capital for the discount rate since it takes into consideration the rate of return expected by shareholders. If the DCF calculated is above the current cost of the investment, then the opportunity could result in positive returns. However, bearing in mind that DCF relies on estimations of future cash flows which could prove to be inaccurate, this ratio does have its limitations.

 

Making any investment decision involves a meticulous process of taking several elements into consideration. Applying ratios may take much of the excitement of investing, however, understanding what they tell you and where to find all the information needed to calculate them can give you greater confidence in your decisions, while they can help you pick the best investments for your portfolio.

Making use of just one ration in isolation is not enough though, so you should combine these to get a better and more complete picture of a company’s prospects. If, however, the investment ratios mentioned above make your head spin, your best bet is to get in touch with a professional. By addressing clients’ unique needs and taking into consideration the complexities of your finances, your personal circumstances, as well as your short and long-term objectives, CC’s financial advisors can identify the best investment opportunities leading to your success. Have a look at our various investment opportunities and get in touch with one of our advisors today to get started.