There’s no way around it, you need to do some homework and math if you’re thinking about buying stocks.
But which sums make the most sense for investors when weighing up a stock? And how do you find the numbers you need in a company’s financial reports?
Sheridan Admans, head of fund selection at investment platform Tillit, walks us through some basic math that tells us whether a company is undervalued or overvalued and whether its finances are sound.
Stock research: Which sums make the most sense for investors?
Price-to-earnings or P/E ratio
Price divided by earnings per share
A company’s PE ratio should be assessed in relation to the P/E ratio in the broader sector. This tells you how a company performs compared to its peer group. However, as a rule of thumb, a high PE indicates that there is a higher risk.
Companies’ PE ratios are easy to calculate yourself and can be found in most good stock lists in online market data, for example This is Money’s individual stock pages, such as this one for BP shares, which show PE ratios .
It can be harder to find PEs for the FTSE sector unless you are a professional investor, but you can try tracking them down online for free. Alternatively, an underwriting stock information service like Stockopedia – which This is Money recommends for serious stock investors – shows PEs compared to industry/sector levels.
It makes sense to compare a company’s P/E ratio with that of its industry. “A comparison will give you an idea of whether it’s below or above the industry average,” says Sheridan Admans of The Share Centre.
“Is below the industry average and undervalued or there is a problem.”
“Then you start looking for which of the two it is.”
“If it’s above average, it’s overvalued or there’s been a change in the company, a shift in its ability to grow revenue.”
Sheridan Admans: You should compare a company’s P/E ratio to its industry
To find answers, look at the business review section of an annual report to see what the company has done and what it plans to do in the future, says Admans.
And for the sake of thoroughness, he suggests reading through the annual reports from the last few years again to see what ambitions the company had back then and how successfully it fulfilled them.
He urges investors to pay close attention to the management structure, particularly any changes to the board. When new positions open up, read their resumes.
According to Admans, the annual report gives you a real feel for the company.
He says one then needs to ask whether the current valuation is sustainable, whether management is doing enough to support a higher valuation, and whether the company has a credible plan that can realistically be achieved.
One reason to look at industry PEs is that the norm varies greatly from industry to industry. For example, Admans notes that technology companies tend to have much higher P/E ratios than manufacturing companies.
A manufacturer with a P/E ratio of 80 would send investors fleeing, but technology companies often have P/E ratios between 50 and 80.
“They can grow revenue faster and launch in regions and continents faster than a widget manufacturer,” explains Admans.
“You have to understand the company and ask whether this valuation is justified.”
Return on equity
Net profit divided by equity
Return on equity tells you how efficiently a company is using its equity, says Admans.
“It measures the profitability of the company based on the money invested by shareholders.” The higher it is, the better. And you want it to be sustainable.”
He says you need to go back and calculate return on equity over several years. If it is constant it suggests stability, but if it has gone up and down it suggests there is a source of instability.
This could be the economic environment, starting a new business or investing abroad and you should do some research to find out.
“You have to collect all the information and form an opinion at the end,” says Admans.
Interest rate protection
Earnings before interest and taxes (EBIT) divided by interest expense
Interest coverage tells you whether a company can meet interest payments on its debts.
“If not, do you want to invest in them?” “At some point there will be a problem,” emphasizes Admans.
He says you look for safety at values above 1 and preferably above 1.5.
Anything below 1 or close to it should raise alarm bells about whether a company will be able to keep up with interest payments.
Earnings per share divided by the total annual dividend
“Is your dividend covered? If not, that means it comes from capital. “At some point the dividend will be cut or disappeared completely,” says Admans.
If a company cancels its dividend, income investors and income funds will exit the stock.
“At some point it will have a significant impact on the stock price and your personal wealth,” warns Admans.
On the other hand, a company that continually increases its dividends can generate great returns, especially if you continue to reinvest them in more stocks.
Many companies have a dividend policy, which may consist, for example, in which distributions to shareholders are broadly covered twice by profits. So read up on it and consider how likely it is that management will stick with it.
Current assets divided by current liabilities
This is a liquidity ratio that measures the company’s ability to meet its short-term obligations, explains Admans.
“A ratio below 1 suggests that the company may not be able to meet its obligations as they fall due at that time,” he says.
“This doesn’t necessarily mean the company will go bankrupt, as there are many ways to obtain funding.”
“It provides insight into the efficiency of the company and its ability to convert products into money.”
However, it is worth remembering that operations are different in each industry, so it makes sense to compare companies within the same sector or industry.”
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