By Glen James
Once you’ve reviewed the basics of a company and dug into the management, dig down into the financials of the company before deciding to invest. Here are some key financial ratios to help compare one company with another.
Of course, no ratio guarantees the share will perform the way you expect it to. But knowing these six investment ratios will help you identify shares you may want to buy and hold.
Many financial websites have already run the equation and posted the figure for you, but familiarise yourself with what these numbers mean in the real world. After all, you will be investing real money into real companies to get a real return.
1. Price-to-free-cash-flow ratio
Free cash flow is how much money a company has after it pays the bills. By subtracting a company’s operating expenses, and other expenses used to buy or upgrade assets like buildings and equipment, you are left with free cash flow.
To determine the price-to-free-cash-flow ratio, divide the company’s market capitalisation by its free cash flow. Or you can divide its share price by its cash flow per share if you have that figure handy.
Historically, investors like to see a ratio under 10. The lower the number, the ‘better’ the value of the share.
2. Price-to-sales ratio (P/S)
The price-to-sales ratio (P/S) is also known as a sales multiple or revenue multiple. The market agrees that the lower the P/S of a company, the better value you are getting as a shareholder, because you are paying less for every dollar of a company’s revenue.
To figure out the P/S ratio, divide the share price by sales per share. Or you can calculate the company’s market cap divided by its total sales.
Like all ratios, the P/S makes most sense when you are comparing companies in the same industry. You would expect a tech company and an energy company to have wildly different P/E ratios, so there’s no point in comparing apples with oranges.
3. Earnings-per-share (EPS) ratio
A valuable metric for measuring the potential growth of a share is the EPS, because when you buy shares, you participate in the future earnings as well as the potential of missed earnings and therefore share depreciation.
EPS is a measure of the profitability of a company. As a long-term investor, you will use it to find out for yourself the potential value of a company.
The company’s analysts calculate EPS for you and the number will be readily posted on most financial websites. They calculate it by dividing net income by the weighted average number of common shares outstanding during the year: Net Income / Weighted Average = Earnings Per Share.
The EPS can be zero or negative if a company has no earnings or negative earnings, representing a loss. You want to see a high EPS, because the higher the EPS, the greater the value of your shares.
4. Return on invested capital (ROIC) ratio
Money has a cost to it, either loaned from a bank or acquired through the sale of shares. The capital or money a company acquires costs it something. So, the way it deploys that capital needs to exceed the cost of the capital for it to be a good, profitable company.
Can it earn high returns on the capital it is given? That’s what the ROIC tells you.
When reviewing a company’s ROIC, you want to see that it was able to borrow at, let’s say, 5 per cent and generate 15 per cent on that borrowed money, for a 10 per cent return on capital spread.
5. Price-to-earnings (P/E) ratio
The P/E ratio is used as a metric to compare the price of this share vs the price of another share, as well as how much you are willing to pay for a share of a company now for future earnings.
If a company has a P/E of 21, that means investors are willing to pay $21 for every dollar of generated revenue of the company. So, if you are buying shares in a company, you want to be fairly confident it has plans for future growth.
While many investors focus on the P/E ratio to determine whether a share is cheap or good value, many great investors focus on whether the company can make money on its money and whether it lets the share price work itself out over the long term.
6. Dividend yield ratio
The dividend yield ratio is not the most important investment number, but probably is my favourite. I love it when my money makes money, and when you purchase shares of a dividend company, you have the potential upside growth of the company in terms of share price as well as the dividend payout from the free cash flows of the company.
Most companies pay out the dividend once a quarter, but many companies, like REITs, pay out monthly dividends.
Almost every broker will show you the ‘Div Yield’, but if you want to figure it out yourself, it is calculated using the following formula: Dividend Yield = (Current Share Price / Annual Dividends per Share) x 100.
If a company pays an annual dividend of $2 per share and the current share price is $40, the dividend yield would be calculated as follows: Dividend Yield = ($2/$40) x 100 = 5%.
Edited extract from The Quick-Start Guide to Investing: Learn how to invest simpler, smarter & sooner by Glen James & Nick Bradley.
