There’s no getting around it, you need do some homework and maths if you’re thinking of buying shares.
But which sums are the most useful to investors when weighing up a stock? And how do you track down the figures you need in a company’s financial reports?
Sheridan Admans, investment manager at The Share Centre, guides us through some basic arithmetic that will indicate whether a company is undervalued or overvalued, and if its finances are sound.
Researching shares: Which sums are the most useful to investors?
Price earnings or PE ratio
Price divided by earnings per share
A company PE ratio should be assessed in relation to its wider sector PE – this tells you how a business is performing in relation to its peer group. But as a rule of thumb, a high PE indicates there is more risk attached.
Company PE ratios are easy to calculate by yourself and you can find them in most good share listings in online market data, for example, This is Money’s individual share pages, such as this one for BP shares, show PE ratios.
FTSE sector PEs can be harder to come by unless you are a professional investor, but you can try to track them down online for free. Alternatively, a subscription share information service, such as Stockopedia – which This is Money recommends for serious share investors, shows PEs compared to industry / sector levels.
It is useful to compare a company’s PE ratio to that of its sector. ‘Getting a comparison gives you an idea of whether it’s below or above the sector average,’ says Sheridan Admans of The Share Centre.
‘Below the sector average and it’s under-valued or there is a problem.
‘You then start looking for which one of the two it is.
‘If it’s above average it’s over-valued or something has changed in the business, a shift in its ability to grow revenue.’
Sheridan Admans: You should compare a company’s PE ratio to that of its sector
To find answers, turn to the business review section of an annual report to see what the company has been up to and what it aims to do in the future, says Admans.
And to be thorough, he suggests reading back through the last few years’ business reviews as well to see what its ambitions were then and how successfully it has fulfilled them.
He urges investors to pay close attention to the management structure, particularly any changes to the board. If there are new appointments, read their CVs.
The business review is where you really get a feel for the business, according to Admans.
He says you must then ask yourself whether the current valuation is sustainable, if the management is doing enough to support a higher valuation, and does the firm have a credible plan that can realistically be achieved?
One reason to look at sector PEs is that the norm varies widely between industries. For example, Admans notes that technology firms tend to have much higher PE ratios than those in the manufacturing sector.
A manufacturer with a PE of 80 would make investors run for the hills, but tech companies often have PEs of between 50 and 80.
‘They can grow earnings faster, roll out to regions and continents faster than a maker of widgets,’ Admans explains.
‘You need to understand the company and ask can that valuation be justified.’
Return on equity
Net income divided by shareholder equity
The return on equity will tell you how efficient a company is being with shareholder equity, says Admans.
‘It measures the company’s profitability with the money shareholders have invested. The higher it is the better. And you are looking for it to be sustainable.’
He says you will need to go back and calculate the return on equity over several years. If it is consistent that shows stability, but if it has gone up and down that indicates there has been some source of instability.
This could be the economic environment, the launch of a new business, or an investment overseas, and you should do some research to find out.
‘You need to collect all the information and come up with an opinion at the end,’ says Admans.
Earnings before interest and tax (EBIT) divided by interest expense
Interest cover tells you whether a company can meet the interest payments on its debt.
‘If not do you want to invest in them? Eventually there is going to be a problem,’ points out Admans.
He says you are looking for the reassurance of any figure above 1 and preferably above 1.5.
Anything less than 1 or around it should ring alarm bells over whether a company will be able to keep up with interest payments.
Earnings per share divided by total annual dividend
‘Is your dividend covered? If not, that means it’s coming out of capital. At some point the dividend is going to get cut or disappear completely,’ says Admans.
If a company axes its dividend, income investors and income funds will bail out of the stock.
‘Somewhere down the line it’s going to have a significant impact on the share price and your personal wealth,’ Admans warns.
On the other hand, a company that consistently grows dividends can bring great returns, particularly if you keep reinvesting them in more shares.
Many companies have a dividend policy, which might be for example that payouts to shareholders are broadly twice covered by earnings, so find out what it is and consider how likely management is to 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 under 1 suggests that the company would be unable to meet its obligations if they came due at that point,’ he says.
‘It does not necessarily mean that it will go bankrupt as there are many ways to access finance.’
‘It does provide some insight into the company’s efficiency and its ability to turn products into cash.
It is worth remembering though that operations in each industry differ so it is useful to compare companies within its same sector or industry.’
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