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Ratios
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You can pull ratios from figures in the accounts,
or you can find them made up for you in any newspaper
or on financial websites and software. They enable
you to value companies on fundamentals against
their own past and their peers. But if the same
ratio for two companies was calculated differently,
the differences must be reconciled to make a like-for-like
comparison. Let us now look at some key ratios.
Earnings per share
The earnings per share (EPS) is a measure of the
company’s profitability. It is the profit
attributable to the ordinary shareholders (ie
profit before ordinary dividends) divided by the
number of ordinary shares in issue during the
year. The City looks for an EPS that rises steadily,
even if slowly, year by year, and rewards companies
that can demonstrate it.
Listed companies are required to disclose two
measures of EPS, basic and diluted, on the front
of the profit & loss account. The diluted
EPS figure adjusts the basic EPS figure to show
what the result would have been had all potential
ordinary shares (such as employee share options
and convertible debt) been converted into shares.
Companies can also provide an adjusted EPS figure
but in the notes to the accounts and not on the
face of the profit & loss account. The adjusted
figure may show earnings before items that the
directors prefer to exclude.
Price/earnings ratio
The price/earnings ratio is the share price divided
by earnings per share. It is how the market rates
a stock and shows how many years it will take
the company, at the applicable rate of earnings,
to earn the equivalent to its market value.
If the company’s P/E ratio is low compared
with that of its peers, the shares are looking
cheap. They could be good value, but are very
likely to be depressed for a reason.
If the company’s P/E ratio is high compared
with that of its peers, the shares are looking
expensive, but it could be for a good reason.
The historic P/E is listed in the newspapers and,
to find the sector and market averages for comparison
purposes, you should look at the FT’s Actuaries
Share Indices (The UK Series) in Monday’s
Financial Times.
The prospective P/E is more up to date than the
historic figure because it is based on the future
analysts’ earnings forecasts, but is also
less reliable because they can be wrong.
The P/E ratio can tell you something about the
broader market. In the five years to mid-2006,
the P/E ratio steadily fell in Britain but French
and German P/E ratios ended up slightly higher,
according to analysts. The Times said in a leading
article on 3 July 2006 that a growing gap between
the UK and its European competitors had to raise
serious questions about how the market was judging
the British economy.
The P/E ratio has limitations. It does not take
account of a company’s earnings growth,
which is important for small companies.
A PEG to hang your valuation
on
The price/earnings growth ratio, known as PEG,
redresses the balance by combining an assessment
of growth with the P/E ratio, and is used to value
small growth companies. The ratio is calculated,
either on an historical or prospective basis,
as the P/E ratio divided by the average growth
rate of earnings per share.
Investment guru Jim Slater has advocated a PEG
of well under 1 as a criterion for selecting growth.
If a company has a prospective P/E ratio of 10
and earnings per share growth of 20 per cent,
the PEG ratio is 10 divided by 20, which is 0.5
and, on Slater’s criterion, very attractive.
A stock with a prospective P/E of 30 and earnings
per share growth of 15 is on a PEG of 2, which
he finds too high.
Net assets
To value property companies, investment trusts
or composite insurers, use the share price/net
asset value (NAV) per share. This is the company’s
total assets less its liabilities, debentures
and loan stocks, divided by the number of shares
in issue.
If a company is trading on a low share price/NAV,
it may be a bargain, or have problems that are
not easily resolvable and that make it a poor
investment.
Check how the net asset figure is made up. Properties
historically valued on the balance sheet may be
worth more because of subsequent capital gains.
Machinery may be valued too low owing to a conservative
depreciation policy (see box below).
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Depreciation
Depreciation is the gradual reduction in value
of a fixed asset as it is used by the business
over its useful life. It is expressed as an annual
deduction from the income statement. For intangible
assets, amortization is used instead.
Companies have a choice in how they calculate
depreciation. The method they choose will have
its own impact on reported profits. Com¬panies
should use a consistent method unless there is
a good economic reason for changing.
In practice, there are two common methods of depreciation
for UK companies. The most popular is the straight
line method, which spreads the cost of the asset
equally over its expected economic life. For example,
a company may depreciate an asset valued at £10,000
by reducing its value by £1,000 annually
over 10 years.
The second most popular way to depreciate assets
is the reducing balance method. This way the asset’s
value is reduced annually by a given percentage.
Gross yield
The company’s gross yield is the gross annual
dividend expressed as a percentage of the share price.
It is useful for comparing companies in terms of income.
The more a company’s share price falls, in reflection
of poor perceived prospects, the higher the gross yield
rises. Stocks out of favour may have high yields, and
there is a school of contrarian investing that favours
buying them.
High yield investing can backfire because too many of
the stocks are duds, although, across blue chip companies
over the long term, the method has often outperformed
the market average.
Dividend cover
Dividend cover is how well earnings cover dividend payments.
It is calculated as earnings per share divided by dividend
per share. If it is not at least one, the dividend is
not covered by the company’s earnings and the
company may dip into reserves to maintain or increase
it, so keeping up appearances. The problem may be temporary,
or the slippery slope towards a dividend cut, and city
analysts may be relied on to draw attention to it.
Current and quick ratio
Liquidity is how much cash a company can lay its hands
on at short notice. The way to check this is the current
ratio, which is the company’s current assets divided
by current liabilities (figures available on the balance
sheet). As a rule of thumb, this should be at least
two.
The quick ratio, known colloquially as the acid test,
is a more stringent liquidity test. It is current assets
less stock and work-in-progress, divided by current
liabilities. It should ideally be over one.
Enterprise value/EBITDA
Quoted companies in the high-tech and telecommunications
sectors may have neither yield nor earnings and be paying
interest on substantial debt. In their own sectors’
terms they may be great companies, or potentially so,
but some are not. Analysts prefer to use valuations
suitable for such companies, and a favourite is the
EV/EBITDA ratio.
The EV is enterprise value, which is market capitalization
(share price × number of shares in issue) plus
debt less cash. The EBITDA is earnings before interest,
tax, depreciation and amortization.
The usefulness of EV/EBITDA is that it ignores the interest
payment burden of debt, which is typically heavy in
the sectors to which the ratio is applied. The EBITDA
concept was used by analysts to value WorldCom, the
US telecommunications group where, in June 2002, a US~$11
billion accounting fraud was revealed. A month later,
the company made a bankruptcy protection filing. Analysts
then stopped using EBITDA as a standalone stock valuation
tool. But it is still considered very valuable, and
Anthony Bolton says that it is one of the ratios he
scans in stock picking for his Fidelity Special Situations
Fund.
Return on capital employed
The return on capital employed (ROCE) is a widely used
measure of manage¬ment performance. It may be calculated
as profit before interest payable and tax, divided by
year-end capital employed, which consists of total assets
less total liabilities excluding long-term loans.
The higher a company’s ROCE, the better the company
is at using the assets at its disposal. Ideally, the
ROCE should be rising year-on-year.
Gearing
The gearing ratio expresses the company’s level
of borrowing. It is the percentage of interest-bearing
loans and preference share capital, divided by ordinary
shareholders’ funds. As a rule of thumb, if gearing
is over 50 per cent, it could be cause for concern.
Price/sales ratio
It is pointless trying to apply the P/E ratio to small
companies that have not yet shown a profit because the
earnings component will be nil. In such cases, the price/sales
ratio (PSR) can be an alternative and it is often used
for high-tech growth companies.
The PSR is calculated as market capitalization divided
by last year’s sales. The PSR could be as low
as five or six, or as high as 30 or 40 and, if it is
low, it could represent value. The only way to assess
whether the ratio is too high or low is by comparing
it with that of the company’s peers.
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