INVESTOR EDUCATION
Key Numbers to Look at when Buying a Stock
Key numbers to assess when buying a stock relate to valuation, risk, and future profitability. Under these
areas we walk through 4 commonly used investment metrics: price to earnings, dividend yield, leverage,
and earnings per share growth. Further, when assessing financial metrics of a company, there are two
important ways to look at metrics 1) assessing metrics on a standalone basis, in relation to the company
itself versus its own history, and 2) comparing the metrics to other companies.
Price to earnings Ratio (PE)
There are variations on ratios which compare profits to values of a firm, such as Economic Value/EBITDA, however price to earnings is the most widely used measure.
The formula for this ratio is:
Share Price / Earnings Per Share
Earnings per share (EPS) is calculated by dividing the net profit (earnings) of a company
by the number of shares in the company.
In essence, the price-earnings ratio indicates the dollar amount an investor can expect
to invest in a company in order to receive one dollar of that company’s earnings. If a company is currently trading at a PE of 20 it implies an investor is willing to pay $20 for $1 of earnings. The most commonly used PE which analysts is the “one year forward PE”, which uses the earnings estimated for the year ahead to value the firm as stock prices are forward looking (rather than using historical earnings figures).
In general, a high PE suggests a stock is expensive, and investors may be expecting high
growth in earnings in the future. A low PE may suggest the stock cheap or undervalued.
Although there are often reasons for a low PE and investors must analyse the
underlying drivers of a PE multiple before making conclusions.
Dividend Yield
Measures the income received from holding a stock, and in general a higher dividend
yield indicates that a stock may be “cheaper” and trades at a lower valuation.
Dividends Per Share / Share Price
Dividends per share (DPS) is calculated by dividing the total dividends of a company by
the number of shares in the company.
The dividend yield of a stock is expressed as a percentage and is a measure of the
income an investor will receive by holding a stock (in the form of dividends). As with
PE, analysts usually focus on dividends for the year ahead, as investors are interested
in how much income they can expect to receive for the year ahead if they bought the
stock. A higher dividend yield generally makes the stock more attractive to investors,
especially those seeking income.
Debt to Equity (Leverage)
Is one assessment of company risk, looking at the level of Debt the Business has relative
to its Equity, and is a measure of how likely it is that the business could become
financially distressed (and eventually bankrupt).
Total Liabilities / Shareholder Equity
The ratio provides a general indication of a company’s equity-liability relationship, and
some variations of the formula use net debt obligations instead of total liabilities.
In general a higher ratio means the company is more risky, while a lower leverage ratio indicated the company is safer and may be more conservative.
Earnings Per Share Growth (EPS Growth)
As mentioned above, earnings per share (EPS) is calculated by dividing the net profit
(earnings) of a company by the number of shares in the company. Hence analysts are
often interested not only on what EPS is for the current year in question, but also what
level EPS will be in the proceeding year.
For example we may know that while a company may experience low profitability on 2016, it will be temporary and in 2017 profits are set to grow strongly. These considerations will be kept in mind by investors and reflected in share prices.
An Example – Wesfarmers vs Woolworths
Below are the investment metrics discussed for 2 Australian consumer giants,
Woolworths and Wesfarmers. When deciding on which company is a better
investment, we would look at the ratios discussed:
WESFARMERS (WES.AX)
KEY METRICS
Price to Earnings Ratio 16.9x
Dividend Yield 5.5%
Debt/Equity 24%
EPS Growth 8.4%
WOOLWORTHS (MYR.AX)
KEY METRICS
Price to Earnings Ratio 16.8x
Dividend Yield 5.0%
Debt/Equity 29%
EPS Growth 2.0%
Starting with PE, both stocks trade on approximately the same multiple (16.9 and 16.8),
so from that point of view we cannot argue one is particularly cheap/expensive.
Moving on to dividend yield, Wesfarmers has a higher yield of 5.5% versus 5.0% for
Woolworths. Hence Wesfarmers is a more attractive investment on the basis of
dividend yield.
Looking at debt to equity, Wesfarmers again looks like a safer investment with debt to
equity of 24%, versus 29% for Woolworths.
Finally, looking at the future growth in earnings for the 2 companies, Wesfarmers
earnings are forecast to grow at a much higher rate growing 8.4% from 2016 to 2017,
while Woolworths are only forecast to grow by 2.0%. Hence this would also imply that
in 2017 Wesfarmers will be cheaper than Woolworths as earnings are used in the PE
calculation. Wesfarmers is the more attractive stock based on earnings potential going
forward.
Overall, as a whole Wesfarmers looks to be the superior investment, based on financial
ratios alone.
