Investment Education – Financial Metrics

What is Earnings Per Share?

Equation: net profit divided by the number of ordinary shares in issue.

It represents the portion of profit allocated to each outstanding share.

It allows investors to observe the growth in profits for each share held.

Diluted EPS expands on basic EPS by including the shares of convertibles or warrants in the number of shares outstanding.

What is Price to Earnings Ratio?

Equation: share price divided by the earnings per share.

The P/E ratio represents the number of years it will take for the earnings of a company to cover its share price. Essentially, it is how much investors are willing to pay for £1 of earnings.

A high PE ratio means the investors are bullish on the company prospects and expect it to perform well.

Conversely a low ratio means that investors aren’t expecting much growth, it might indicate an undervalued company.

It’s not an absolute measure and is best used when comparing companies within the same sector.

Investopedia’s animated video explaining what a P/E ratio is.

The Cyclically adjusted price to earnings ratio (CAPE)

Whereas a PE ratio is the share price compared to one year’s earnings, the CAPE (or Shiller PE) is an average of ten years earnings compared with the latest price.

The purpose is to smooth out fluctuations within the business cycle rather than base it on a snapshot, which is what the conventional PE multiple does.

What is the PEG (Price to Earnings Growth) ratio?

Equation for PEG ratio: price to earnings divided by the growth rate of a company.

It’s the price earnings to growth ratio. It is used to gauge to relative value of a stock versus the company’s growth rate.

It is P/E ratio in the context of the company’s growth rate for the year ahead. Because it takes into account growth rate; it is favored by many over the P/E ratio.

A PEG of 1 indicates the company is fairly valued, a PEG of below 1 means a company is priced below its expected growth rate and indicates an undervalued company, above 1 indicates an overvalued company.

With PEG ratio, the numbers are projected and can be less accurate.

Investopedia’s animated video on the PEG ratio.

Price to Book ratio

Equation: Current stock price / (Assets – Liabilities).

It compares a stock’s market value to its book value.

It shows what shareholders will get after the company is sold and all its debts are paid off.

Low P/B Ratio could mean stock is undervalued.

Investopedia’s animated video on the P/B ratio.

Price to Sales

Equation: Current share price / Sales revenue per share (trailing 12months)

The lower the P/S the better the value, its more useful when comparing similar companies.  Advantages being that sales is harder to manipulate than earnings.

However this valuation metric is less useful for service companies like banks/insurers which don’t really have sales.

This ratio should not be used in isolation.

Free Cash Flow

Equation: FCF = Operating Cash Flow – Capital Expenditures

FCF is a measure of how much cash a business generates, after accounting for capital expenditures (money spent to maintain or acquire land, buildings or equipment). This cash can be used for dividends, expansion or reducing debt.

Operating cash flow is EBIT (earnings before interest and taxes) + Depreciation – Taxes. EBIT is also known as operating income.

Price to Free Cash Flow

Equation: Market capitalization divided by free cash flow.

A valuation metric which compares a company’s market price to its level of annual free cash flow.

Profitability Ratios

Return on Capital Employed (ROCE)

Equation: Earnings Before Interest and Tax (EBIT) / Capital Employed (Total Assets – Current Liabilities).

ROCE is defined as the profit made by a company divided by the total amount of money (capital) which has been invested in the business. This ratio indicates the efficiency and profitability of a company’s capital investments.

A higher ROCE indicates an efficient use of capital. It should always be higher than the cost of borrowing, otherwise the company won’t be generating shareholder value.

Investopedia’s short animated video on – ‘Return On Capital Employed’ – http://www.investopedia.com/video/play/return-capital-employed-roce/

Interesting Reads:

One of best explanations of ROCE that I can find is from Charlie Huggins, fund manager at HL – ROCE – What is it and why do we like it?

Return on Equity (ROE)

Return on Equity = Net Income/Shareholder’s Equity (Total assets – Total Liabilities)

ROE measures how much profit a company generates with the money shareholders have invested.

Essentially, as a shareholder how much bang for the buck are you getting?

Net Profit Margin

Profit Margin = Net Profit/Total Revenue

It represents the percentage of total revenue that a company keeps as profit. The higher the profit accrued from the sales of products or services, the greater its efficiency and profitability.

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