This is going to be a bit of a long post, but I hope that I can use it as a way of consolidating the positives and negatives of some popular terms (mostly multiples) that get chucked around financial markets:
1. PE Ratios:
- This effectively asks the question "is this stock is cheap or expensive?"
- It's calculated by taking the current share price (P) of a stock and dividing that figure by the earnings per share (E). Symbolically it's shown as P/E.
- For example: Tesco currently have a share price of 284p and an earnings per share of 23.72p:
284p/23.72=11.9
- This means that if you buy some shares in Tesco right now, you'll be paying 11.9 times one year's earnings, or if you buy some shares at 284p and the earnings per share doesn't change it will take you 11.9 years to make back your invested capital (let alone make any extra - in theory - EPS is not the same as the yearly dividend).
- Now, this number doesn't mean you should either buy or sell Tesco yet, because in order to make some sense from it we have to compare it to some other companies in the same sector (yes, you could argue that Tate and Lyle are in different sectors, but the wider sector all three companies are in is Non-cyclicals):
Sainsbury PE=8.7
Tate and Lyle PE=2
- Well, if Sainsbury has a lower PE ratio than Tesco than it perhaps makes Tesco look a bit expensive and if Tate and Lyle have a PE ratio of 2 than this makes both Sainsbury and Tesco look expensive. However, just because a company has a low PE ratio doesn't mean you should buy it. For example, there could be other things going on there which will make the current PE ratio somewhat artificial:
- PE ratios don't factor in the market capitalisation of the company, so you could end up getting a great PE ratio, but terrible liquidity with a very small capped company (although this risk can be reduced with ensuring that you are indeed comparing Apples with Apples when you run your PE ratio checks).
- PE ratios don't say anything about risk, so it could be that Tate and Lyle have a low PE ratio as a result of their high risk that the market have priced into the company (they could have very high levels of set for example).
- PE ratios are based on hindsight, so just because a company has a low PE ratio doesn't mean that another company with a higher PE ratio will not quickly over take it with better earnings per share growth and thus end up with a significantly better PE ratio. This can be checked out by looking at the earnings growth rate, which will help to give guidance.
- PE ratios tell us nothing about dividends and or if the company can actually turn this earnings per share (not what the company actually pays as a dividend) into positive cash flow (with which they pay dividends).
2. PEG Ratios:
- This is like the PE ratio's older brother and just like the PE ratio asks the question "is this share cheap or expensive?" and carries the assumption that people buy shares because they intend to squeeze future earnings out of it (i.e. in theory, a property investor views a house as only as valuable as the future rental income that can be generated from it).
- It's calculated by taking the current PE ratio of a stock and dividing it by the earnings growth rate (EGR) of that stock/ So symbolically we get a formula of PEG= PE/EGR.
- Quite a lot of people tend to prefer this to the standard PE ratio because it factors in the fact that you would hope as an investor to see an increase in earnings per share growth over time (or earnings growth rate). It's worth stating now that earnings growth rates you'll either need to calculate yourself or look online for analysts that have already done it for you.
- For example, let's take Morley Beswick's Stationary Supplies (a company I've just made up so I can use conveniently round numbers):
PE ratio = 10
Earnings growth rate (10p------> 12p)= 20% (leave the '%' part out)
PEG=10/20
PEG=0.5
- Now, a PEG ratio tells you the following (in theory):
PEG=1 the share is fairly priced (or mathematically this would be a PE of 10 and an earnings growth rate of around 10%)
PEG<1 the share is priced cheaply in the market
PEG>1 the share is priced expensively in the market
- The issues with this are that the primary source of data comes from earnings forecasts from analysts, which are notoriously inaccurate. So, before taking a PEG seriously we have to sit down and seriously question the earnings growth rate.
- This also tells us nothing about the dividend or cash-flow (can the firm turn the growth into cash?) and for some companies that are in slow growth sectors like non-cyclicals, actually a PEG ratio probably would be inappropriate because of the sector low EPS growth rate.
3. Dividend Yields:
- This effectively tries to use the income paid by a company and the current share price to give you a return figure as a percentage on your investment (dividend yield).
- It's calculated by taking the dividend and dividing that by the current share price and multiplying that figure by 100%. In symbolic terms it would look like this:
Div/Share Price*100%
- For example, let's say that I buy some shares in Richard Handler's company that makes a similar product to Viagra, we'll call the company Dixafix. Dixafix's share price is currently 580p and their interim and final dividend combined (total dividend) is 30p.
30p/580*100%= 5.1% - or a return of 5.1% in a year.
- Now as with PE ratios, whether this is good or not depends on what else you can do with your money. If you can get 10% from a bank account for almost no risk than that makes 5.1% look pretty bad. You could also shop around through corporate bonds and see what's available there. Comparison is key.
4. Dividend Cover ratio:
- Dividend cover is the idea that of all of the profits that a company makes in a year (let's say £100m), the board of directors won't decide to pay out all of that as a dividend, but will hold some of it back so they can continue to grow the business organically. It effectively asks, "is this dividend yield sustainable?".
- It's calculated by dividing the total earnings per share by the total dividend per share in one year (and then normally followed by multiplying by 100%).
-First we need to have a dividend yield for our example:
total dividend per share/current share price *100%
I have a company with a silly name (Spruce Spring-clean, let's say). I am going to release a dividend of 2p per share. The current share price is 10p.
To derive the dividend cover we therefore take 2 (the total dividend per share) and divide it by 10 (the current share price) and we get 0.2. Multiply 0.2 by 100% and we get our dividend yield of 20%
- Let's work out the dividend cover:
Helpfully, Spruce Spring-clean had an earnings per share of 20p.
so, we take our total earnings per share (20) and divide that by our current share price (2) = 10
- What does this mean?
Well, it means that this divided could have been paid out ten times before they would have run out of profits (in one year) to pay the dividend with. On the face of it, the higher the dividend cover is, the better the company is and generally though a dividend cover of two or more is a good company to go for.
5. Payout ratios:
-It's calculated by dividing the total dividend per share by the total earnings per share and then by multiplying by 100% to make life a little easier:
total dividend/ total earnings per share *100%
- To make life easy we can continue from the dividend cover's example and have a dividend of 2p per share and an earnings per share figure of 20p.
2/20= 0.1 (*100%) =10%
- Generally speaking a high dividend cover is pretty good (with 10% in this case looking low and 30-35% being pretty normal for a standard blue chip stock) because statistically they're reasonably consistent and show that cash is being returned to shareholders.
- Payout ratios tend to come into their own when they're combined with dividend yields and covers. For example, a low payout ratio combined with a reasonable dividend yield and a strong cover could well indicate that the company in question is going to increase their dividend yield substantially in the future.
6. Price to Book ratio
- Once again this asks the question "is this stock cheap or expensive?", but it asks it in reference to the book value of a firm's assets.
- Here's how it's calculated:
share price/ book value per share
- Understanding what this ratio tells us is very important (otherwise I could pull any random number out of the air and use that to invest). Now, the share price is the easy bit to understand (the closing price of a stock), but the book value per share is a little more difficult to get to grips with. In effect, the book value per share looks at what the company owns (it's total assets) and the company's liabilities (who it owes money to) and then works out a net asset position by taking their total asset figure and taking away the total liabilities figure.
- For example, let's pretend I have a house that cost £150,000. I may own £50,000 of that, but the bank I took out a mortgage with will own the other £100,000 of the house. So I have a net asset position of £50,000 (the total asset - the liability): 150,000-100,000.
-This net asset value is then divided by the total number of shares (you'll have to look this up online) that the company has issued to get a book value per share.
- Let's do a full example:
Morley's Piratical Provisions (a hypothetical shop that sells pirate themed food) has a book value of £14,681m (the 'm' means 'million' for those who don't know).
The total number of shares issued is 7,985 million shares.
The current share price is £4.30.
- So, we need to start by taking the book value (£14,681m) and dividing that by the number of shares (7,985m) to get a book value per share:
14681/7985 = 1.84
Now we need to take the current share price (£4.30) and divide that by the book value per share (1.84):
4.30/1.84 = 2.34
- When the price to book ratio is well above 1.0, it's generally accepted that you're paying a lot for shares, because (to use our example above) the current share price is over twice what the company's assets are actually worth.
- If the price to book ratio is less than 1.0 it means that you're getting a good bargain, because actually you're paying less for the shares than the assets of the company are actually worth.
- Now, to tell if this number is good we have to compare the price to book ratio of Morley's Piratical Provisions to that of other companies in similar sectors (for example, ''Dead Men Sell No Snails'' - the anti-French, pirate equivalent of Tesco), which has a price to book ratio of 4.3 - making Morley's Piratical Provisions look pretty good.
- There are a couple of disadvantages with price to book ratios however:
- The nature of accounting rules means that assets can be discounted and intellectual assets are subjective somewhat to how they're valued - meaning you could look at a balance sheet and think something is worth more or less than is actually stated. Other issues can be that in accounting terms you pretty much can't value something as an asset unless someone else has paid a certain price for something exactly the same elsewhere before - hence why football clubs can't list home grown talent as an asset on their balance sheets.
- The other issue is simply that some companies (especially small tech companies) tend to have very little in the way of actual assets, making this ratio meaningless at best and utterly inappropriate to use at worst.
7. Price to Sales Ratio:
- This is a bit of a "meh" ratio in my opinion, although many people do love it, and it (as with the other ratios) asks the question "is this share cheap or expensive?".
- It's calculated like this:
Market Capitalisation/sales (over 12 months)
or
current share price/sales per share
- The first one is often easier to do.
- Here's a pretend example:
I have a company called "Cleftomaniac", which sells music related products. The company has a market capitalisation of £80m and had twelve monthly sales last year of £100m.
So, to work out the price to sales ratio we just divided the market capitalisation (£80m) by last year's total sales of £100m.
80/100 = 0.8
- Studies have shown that when price to sales ratios are below 1.0, future upward share price movement tends to be strong and vice versa. So, below 1.0 is cheap and significantly above 1.0 is expensive.
- Fans of the ratio say that not only is it simple to calculate and interpret, but that the fact that you're using sales, makes it very hard for the company to manipulate it's accounts to show preferential figures. Also, it's a good ratio to apply to smaller firms that are growing very quickly, which may have little or no profit, as they will almost certainly have positive sales figures (if they don't I would seriously rethink why you're investing in them).
- The problem however, is that it ultimately isn't a substitute for the PE ratio, which people were particularly fond of using in the ".com boom", because it could make a company look great even if in reality thee was little to no actual profit being generated. In short, sales are not a substitute for profits!
- Another big issue I have is that it in certain sectors that are asset intensive this ratio is a bit irrelevant (a price to book approach is more appropriate) and the same point applies in financial sectors where they report revenues a bit differently to other sectors.
- The other issue is that you can get caught in a debt trap, whereby the market is worried about the company's debt - something that the price to sales ratio doesn't explicitly deal with. In other words, you can have a price to sales ratio of 0.3 and the company could still carry a high risk of going bust three months later (although this could be calculated by using an enterprise value figure instead of a market capitalisation figure).
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