July 31, 2014

How to pick shares: investment ratios summarised

This how to pick shares tutorial will explain the key investment ratios and terms you will face when buying shares.

The PE Ratio

The Price-Earnings ratio (PE ratio) is one of the most common ratios you will see on a financial website when researching a share. The formula is used to compare the market value of a company with its profits. The PE ratio is equal to the share price / earnings per share.

Therefore if you see a share has a PE ratio of 7, this means that its share price is 49p and its earnings per share is 7p. This means it would take 7 years for the earnings of the share to go beyond the current price of the share. If faced with a decision between multiple shares, logic would suggest investing with the one with the lowest PE ratio if the PE ratio was the only way of selecting shares.

There are multiple versions of the PE ratio including the trailing and forward PE with a focus on historic earnings and forecast earnings over 12 month periods respectively.

The PEG Ratio

The Price-Earnings Growth ratio (PEG Ratio) is an ‘evolution’ of the PE ratio. Using the PE ratio, you may find that two different companies have a PE ratio of 5 and 7 respectively, but this alone will only tell you that the latter share is more expensive.

Essentially, the PEG ratio factors in the growth forecast of a company in order to truly determine the value of a share. The PEG ratio is: PE ratio/forecast earnings per growth.

A theorist has coined the Growth At a Reasonable Price theory (GARP) which assumes that a fairly valued company will have a PE ratio that is equal to its growth rate. Therefore, a fairly valued share should have a PEG result of one, over one would suggest it’s overvalued, and below one would suggest the share is undervalued. It is suggested to use the PEG ratio with companies in a similar field when comparing.

Although there are also limitations of the PEG ratio. The main limitation is that it is relying on a forecast, and a forecast is just that and not a guarantee.

Other Terms to Understand

Some of the most common terms that financial websites will show when researching a stock also include the following:

Earnings per Share (EPS)

As used in the PE ratio, EPS is calculated by dividing the net profit of a company by the number of shares currently in issue. If a company had a net profit of £400m and 20 million shares in issue, it would have an EPS that is equal to £20. A way of interpreting the output of this calculation is how much net profit corresponds to each share.

Dividend Yield

The formula for calculating the dividend yield is dividend / share price. So if the dividend is 50p and the share price is 600p, then the dividend yield would equate to 8.3%. This shows how much a company pays out in dividends relative to its share price. Dividend seekers will understandably be seeking the highest dividend yield if comparing different shares.

Market Capitalisation

This is the total the value of the company as dictated by the market. It is calculated by multiplying the share price by the number of shares outstanding.

 Note

There are plenty of other considerations to take into account when buying shares, but the above are some of the most common ratios used by investors.