Investing

Investment professionals bandy around a lot of technical-sounding words and ratios> but take a little time to learn what they all mean and you’ll get a valuable insight into how much a company’s shares are really worth. Here’s a guide to some of the most frequently used – and useful – terms:

Investment formulae are best used to compare one company to another or to compare a company against its long-term average in a certain area. Beware simple rules of thumb because financial metrics can vary widely across companies and industries.

Earnings per share: Net profit after tax (NPAT) divided by total ordinary shares on issue. Always focus on the amount of company earnings attributable to each share.

Earnings yield: Earnings per share divided by the share price. The P/E ratio is the inversion of this.

Debt/equity ratio: (Total debt divided by shareholders equity) multiplied by 100. Shows how far a company is financed by debt. Also called the gearing ratio.

Dividend cover: Earnings per share divided by dividends per share. Shows the number of times a company’s dividend per share is covered by earnings per share.

Dividend yield: Annual dividends per share divided by the current share price. Expressed as a percentage.

Interest cover: Earnings before interest and tax divided by net interest payments. Shows how many times interest payments are covered by earnings. A higher interest cover suggests the company is more able to meet interest payments.

Payout ratio: Dividends per share divided by earnings per share, as a percentage. It shows the proportion of company earnings that are being paid out as dividends.

Price-earnings (P/E) ratio: Current share price divided by earnings per share. A P/E ratio is one of the most used valuation techniques: it shows how much investors are willing to pay for earnings per share generated by a company. Compare the company’s P/E to others in a similar industry and against its long-term average. Use forecast earnings per share to check the forward P/E.

Price-earnings growth (PEG) ratio: P/E ratio divided by annual earnings per share growth. The PEG ratio can be favoured over the P/E ratio as a valuation tool because it accounts for growth. A lower PEG ratio is considered better value. A ratio of one is considered to be fair value and above that a stock is considered more expensive, in theory.

Return on equity (ROE): Net profit after tax divided by shareholders’ equity. This has subtle variations, such as using average shareholders’ equity over a reporting period. ROE shows how efficiently a company is using its shareholder funds. A high, rising ROE shows effective use of funds.

Shareholders’ equity: Total assets minus total liabilities. Shows what shareholders own.

NB: You may also be interested to read What a company’s financial statements really mean