Investment Basics (5): Investment Ratios
We’ve now covered enough ground in previous articles to look at the basic investment ratios and dig into what they actually mean. As usual the numbers are only a snapshot of the underlying truth. Sadly the truth may not be out there at all.
Price Earnings Ratio (P/E)
The most common investment ratio is the Price Earnings Ratio – generally known as PER or P/E. The PER is simply the current share price of a stock divided by its earnings per share or EPS. Remembering that “earnings” is simply a fancy name for profits you can also calculate PER by dividing the company’s market capitalisation by its total earnings. They’re the same thing.
PER tells you how many years it will take for the total earnings of the company to equal the share price. It’s a comparative measure – you can use it to compare the relative valuation of different companies. Generally similar companies in similar sectors should have similar PERs, all other things being equal.
PER – Factoring Future Growth (or Lack of It)
As a rule of thumb the higher a company’s PER the faster the market expects it to grow. As PER is a historical ratio, calculated on past earnings and current share price, if the earnings increases in future then the number of years it will take to earn back the share price will be less than the PER indicates. Because of this companies in high growth sectors will usually have higher PERs than those in low growth sectors. Remember that future growth in earnings is a guess, although lots of investment analysts spend a lot of time trying to make intelligent estimates of these. Some of them even succeed.
However, sometimes a high PER is a consequence of the market factoring in an expected drop in earnings. When the market expects earnings to fall it will mark down the share price. However, because the earnings used in the PER calculation are historic a fall in share price will see a rise in PER.
PER – Forecasts and Danger
Although the PER is a historical ratio you may also see future or forecast PER’s quoted, which are based on future forecasted earnings and current share price. These will show the change in PER if the expected earnings are achieved and the share price is unchanged. As you’d expect future earnings often drive the current share price – share prices will move to meet the expectations.
Be careful in using PER. You’ll see commentators explaining why a stock is cheap because it has a low one – but as PER is a comparative measure you need to make sure you know what the comparison is with. For example, average PERs have varied significantly across time and markets, depending on whether people are feeling confident or not. When they go in reverse they can stay low for a very long time.
Earnings Per Share (EPS)
The second ratio we need to consider is the one that PER is based on – Earnings per Share or EPS. You might think that earnings – profits – are a pretty straightforward thing but if you dig into company accounts you may well find several different EPS’s quoted and the correct one to use will depend on circumstances.
Nominal EPS is usually called just “EPS” and is the term as we’ve discussed it earlier – it’s the earnings per share based on reported profits. However, there may also be Adjusted EPS and Diluted EPS.
Adjusted EPS and Diluted EPS
Adjusted EPS is where earnings are adjusted for “one off transactions” which affect profits temporarily and also for write offs of goodwill and other intangibles which don’t really affect the profits.
The adjustments may be OK but it’s always worth checking to see exactly what’s in these. There have been plenty of cases where companies have artificially adjusted their profits by including as one-offs things that should be in normal operating expenses. When they do this it always ends up flattering the headline EPS and usually helps executives hit their bonus targets.
Diluted EPS covers the effect of variations in the number of shares in issue, which impacts market capitalisation. Shares can be issued or redeemed for a number of reasons including share options, acquisitions and share buybacks. The Diluted EPS takes account of these factors.
Generally Adjusted EPS is the one to go for, although you need to check those adjustments and if there have been an exceptionally large number of shares issued or redeemed this must also be taken into account – normally the changes in the number of shares in issuance aren’t large enough to really matter but if there’s a big difference between adjusted and diluted EPS this should be investigated.
Net Asset Value (NAV)
We’ve already discussed NAV an number of times but it’s worth going back over the possible types of NAV and what these mean. NAV is a snapshot of a company’s value if you shut it down and sell off its assets. This can be quoted either on a full company valuation against the market capitalisation or on a per share basis against the share price, both have the same meaning.
Typically balance sheets show net assets which are the total assets minus the total liabilities. We have yet to discuss liabilities but these are the debts that the company owes – payments due to suppliers, repayments of loans, etc. This NAV figure will typically contain intangible assets and goodwill which, as previously discussed, may have real value to an acquirer but are meaningless if you’re shutting the company down. Value investors would normally be looking at a slightly different ratio – Net Tangible Asset Value (NTAV).
Net Tangible Assets
You need to be careful in looking at NAV and NTAV because investors will sometimes use the terms interchangeably. A value investor will normally look for companies trading a discount to NTAV, i.e. where the market capitalisation is less than NTAV. However, this assumes that the assets on the balance sheet are accurately valued and that shouldn’t be assumed.
An example might be property. As we are today, in 2009, many property valuations have dropped significantly over the last two years in many countries. So the value of the property on a company’s balance sheet may actually overstate its true NAV. However, it’s also the case that some companies don’t regularly revalue their properties and so these may be on the balance sheet at valuations last made twenty years ago.
Ratios are a Starting, not an End, Point
This just shows, I’m afraid, that looking at the basic investment ratios are only a starting point for the active investor. Once you’ve found a few likely looking candidates then you need to do a bit of digging to see whether you’ve found something really valuable or not. It were simply as easy as checking a few numbers everyone would be doing it successfully. And they’re definitely not.
As a point of historical interest the great value investor Ben Graham used to look for companies trading at a discount to Net Tangible Current Asset Value. This excludes all assets that can’t rapidly be turned into cash and is a much harder hurdle to scale. It’s not something commonly discussed today because, frankly, very few companies ever pass the test. In the past company valuations were commonly a lot lower than we see today.
Yield
One further number that’s often of interest to investors is the dividend – the cash the company pays out to its investors – which is used to calculate the dividend yield, usually just called “yield” as a percentage of the share price. What should be of interest, but is often missed, is another metric called the earnings yield. We’ll look at both of these and how they are related next time out.
Main Points
1. The Price-Earnings ratio = Share Price / Earnings per share
2. PER tells you how many years it will take for historical earnings to add up to the current share price.
3. The P/E ratio allows you compare valuations between companies.
4. Forecast PERs use estimated forecast earnings to look into the future.
5. Earnings per share is the Profit / Number of issued shares
6. Adjusted EPS removes non-recurring one off expenses that reduce the profit (earnings)
7. Diluted EPS adjusts for the number of shares in issue
8. Net Asset Value is the value of all of a company’s assets minus its liabilities
9. Net Tangible Asset value is the value of a company’s assets minus its liabilities minus any intangible assets (including goodwill).
10. All investment ratios are a starting point for investors, not the end of analysis.
Previous Post: Investing Basics (4): Goodwill – The Value of Nothing
Next Post: Investing Basics (6): Searching for Yield
We’ve now covered enough ground in previous articles to look at the basic investment ratios and dig into what they actually mean. As usual the numbers are only a snapshot of the underlying truth. Sadly the truth may not be out there at all.
Price Earnings Ratio (P/E)
The most common investment ratio is the Price Earnings Ratio – generally known as PER or P/E. The PER is simply the current share price of a stock divided by its earnings per share or EPS. Remembering that “earnings” is simply a fancy name for profits you can also calculate PER by dividing the company’s market capitalisation by its total earnings. They’re the same thing.
PER tells you how many years it will take for the total earnings of the company to equal the share price. It’s a comparative measure – you can use it to compare the relative valuation of different companies. Generally similar companies in similar sectors should have similar PERs, all other things being equal.
PER – Factoring Future Growth (or Lack of It)
As a rule of thumb the higher a company’s PER the faster the market expects it to grow. As PER is a historical ratio, calculated on past earnings and current share price, if the earnings increases in future then the number of years it will take to earn back the share price will be less than the PER indicates. Because of this companies in high growth sectors will usually have higher PERs than those in low growth sectors. Remember that future growth in earnings is a guess, although lots of investment analysts spend a lot of time trying to make intelligent estimates of these. Some of them even succeed.
However, sometimes a high PER is a consequence of the market factoring in an expected drop in earnings. When the market expects earnings to fall it will mark down the share price. However, because the earnings used in the PER calculation are historic a fall in share price will see a rise in PER.
PER – Forecasts and Danger
Although the PER is a historical ratio you may also see future or forecast PER’s quoted, which are based on future forecasted earnings and current share price. These will show the change in PER if the expected earnings are achieved and the share price is unchanged. As you’d expect future earnings often drive the current share price – share prices will move to meet the expectations.
Be careful in using PER. You’ll see commentators explaining why a stock is cheap because it has a low one – but as PER is a comparative measure you need to make sure you know what the comparison is with. For example, average PERs have varied significantly across time and markets, depending on whether people are feeling confident or not. When they go in reverse they can stay low for a very long time.
Earnings Per Share (EPS)
The second ratio we need to consider is the one that PER is based on – Earnings per Share or EPS. You might think that earnings – profits – are a pretty straightforward thing but if you dig into company accounts you may well find several different EPS’s quoted and the correct one to use will depend on circumstances.
Nominal EPS is usually called just “EPS” and is the term as we’ve discussed it earlier – it’s the earnings per share based on reported profits. However, there may also be Adjusted EPS and Diluted EPS.
Adjusted EPS and Diluted EPS
Adjusted EPS is where earnings are adjusted for “one off transactions” which affect profits temporarily and also for write offs of goodwill and other intangibles which don’t really affect the profits.
The adjustments may be OK but it’s always worth checking to see exactly what’s in these. There have been plenty of cases where companies have artificially adjusted their profits by including as one-offs things that should be in normal operating expenses. When they do this it always ends up flattering the headline EPS and usually helps executives hit their bonus targets.
Diluted EPS covers the effect of variations in the number of shares in issue, which impacts market capitalisation. Shares can be issued or redeemed for a number of reasons including share options, acquisitions and share buybacks. The Diluted EPS takes account of these factors.
Generally Adjusted EPS is the one to go for, although you need to check those adjustments and if there have been an exceptionally large number of shares issued or redeemed this must also be taken into account – normally the changes in the number of shares in issuance aren’t large enough to really matter but if there’s a big difference between adjusted and diluted EPS this should be investigated.
Net Asset Value (NAV)
We’ve already discussed NAV an number of times but it’s worth going back over the possible types of NAV and what these mean. NAV is a snapshot of a company’s value if you shut it down and sell off its assets. This can be quoted either on a full company valuation against the market capitalisation or on a per share basis against the share price, both have the same meaning.
Typically balance sheets show net assets which are the total assets minus the total liabilities. We have yet to discuss liabilities but these are the debts that the company owes – payments due to suppliers, repayments of loans, etc. This NAV figure will typically contain intangible assets and goodwill which, as previously discussed, may have real value to an acquirer but are meaningless if you’re shutting the company down. Value investors would normally be looking at a slightly different ratio – Net Tangible Asset Value (NTAV).
Net Tangible Assets
You need to be careful in looking at NAV and NTAV because investors will sometimes use the terms interchangeably. A value investor will normally look for companies trading a discount to NTAV, i.e. where the market capitalisation is less than NTAV. However, this assumes that the assets on the balance sheet are accurately valued and that shouldn’t be assumed.
An example might be property. As we are today, in 2009, many property valuations have dropped significantly over the last two years in many countries. So the value of the property on a company’s balance sheet may actually overstate its true NAV. However, it’s also the case that some companies don’t regularly revalue their properties and so these may be on the balance sheet at valuations last made twenty years ago.
Ratios are a Starting, not an End, Point
This just shows, I’m afraid, that looking at the basic investment ratios are only a starting point for the active investor. Once you’ve found a few likely looking candidates then you need to do a bit of digging to see whether you’ve found something really valuable or not. It were simply as easy as checking a few numbers everyone would be doing it successfully. And they’re definitely not.
As a point of historical interest the great value investor Ben Graham used to look for companies trading at a discount to Net Tangible Current Asset Value. This excludes all assets that can’t rapidly be turned into cash and is a much harder hurdle to scale. It’s not something commonly discussed today because, frankly, very few companies ever pass the test. In the past company valuations were commonly a lot lower than we see today.
Yield
One further number that’s often of interest to investors is the dividend – the cash the company pays out to its investors – which is used to calculate the dividend yield, usually just called “yield” as a percentage of the share price. What should be of interest, but is often missed, is another metric called the earnings yield. We’ll look at both of these and how they are related next time out.
Main Points
1. The Price-Earnings ratio = Share Price / Earnings per share
2. PER tells you how many years it will take for historical earnings to add up to the current share price.
3. The P/E ratio allows you compare valuations between companies.
4. Forecast PERs use estimated forecast earnings to look into the future.
5. Earnings per share is the Profit / Number of issued shares
6. Adjusted EPS removes non-recurring one off expenses that reduce the profit (earnings)
7. Diluted EPS adjusts for the number of shares in issue
8. Net Asset Value is the value of all of a company’s assets minus its liabilities
9. Net Tangible Asset value is the value of a company’s assets minus its liabilities minus any intangible assets (including goodwill).
10. All investment ratios are a starting point for investors, not the end of analysis.
Previous Post: Investing Basics (4): Goodwill – The Value of Nothing
Next Post: Investing Basics (6): Searching for Yield
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