Financial analysis ratios allows investors a quick and effective way to measure company performance either against previous periods or against competitors.
There are a number of financial analysis ratios and here are some highlights. Investors can also use the ratios below to evaluate the overall market (as well as index funds)
Price to Earnings Ratio (P/E) – It is a multiple of the current price against the shares earning. This can be a historical (current earning per share or trailing twelve month earning) or as a forward looking multiple by using the forward earning per share. The forecast can be from management guidance or consensus analyst estimates.
We prefer forward earning ratio as investment is a forward looking exercise while what happened in the previous years are important in the investment context, current investors in the stock are not earning historical earnings but what the market or investors expect the future earnings are.
Earnings Yield is the inverse of the P/E ratio. This ratio measures the business income per the share over a 12 month period. As an equity investor, investor share of income is proportional share of the total company. It is a good measure of total income the company can be paid out.
There are 2 primary financial ratios investors should use in looking at dividends. These include payout ratio which is the percentage of the earning that is paid out and the dividend yield which shows actual income distributed by the company.
Australian investors should also be conscious of the franking credit embedded in the dividends.
Price to Book Ratio (P/B) – P/B highlight the current price as multiple of the tangible assets. It is not a one size fits all approach valuation ratio for all industries. It is important measure for Real Estate Investment Trusts (REIT) as if you’re investing in a REIT, you are essentially investing in physical assets and would be conscious of a good reason to pay beyond P/B of 1.
One the other hand, for technology companies where expectation of earnings and earning growth means that P/B ratio is not as important.
Fast growing companies can be difficult to value as the current price is a present value of its future earnings. The problem is future earnings is dependent on the assumptions used.
Price to Sales (P/S) can be used in this instance since growth shares has limited earnings (due to current investment spending outpacing income).
On another level the above ratio can be manipulated to find relative value. One of our favourite financial ratio is the Price Earning Growth Ratio (PEG).
PEG = Price Earning Ratio / Growth Rate
PEG is a combination of price earning ratio which incorporate the growth rate of the company. As a value investor with growth focus. We like growth but just at a reasonable price.
Therefore by using the above ratio, we can identify high PE stocks and associated growth rate can be cheap relative to low PE share with a even lower growth rate. The sweet spot is low P/E share with a high expected growth rate.
Our model portfolio holdings in the some of the best australian shares is a manifestation of the PEG concept.