Share evaluation techniques
There are too many ratios to mention here but an important measure of efficiency is the operating profit margin. The operating profit margin measures how much profit a company is making from its core business. All revenue less direct costs gives the operating profit which is then divided into the revenue as a percentage.
The equation excludes indirect costs such as tax paid, interest on debt and other non-direct items. The result is compared to previous years as well as competitors to learn how well a company is turning revenue into profit. The ultimate investment decision lies in the compilation and comparison of valuation ratios.
There are hundreds of valuation ratios but perhaps the most important of these is the price-earnings (PE) ratio, which is the price of a share divided by the earnings per share (EPS).
For instance, a share trading at R100 per share with EPS of R5 would have a PE of 20 and at current earnings would take 20 years before the earnings pay off the share price. A share trading at R200 may appear more expensive but if it has an EPS of R20 its PE would only be 10 so would in fact pay for itself in half the time. A high PE does not necessarily mean that a share is expensive especially if the company is experiencing strong earnings growth.
Another important ratio is the dividend yield. A company may decide to pay some of its profit to shareholders. If the company above trading at a price of R100 pays out a dividend of R2 the dividend yield would be 2%. Shareholders would receive 2% of the current share price back in cash.
A higher dividend yield is beneficial but does not necessarily mean a better company. Some companies may not pay a dividend as they are in a growth stage and need to reinvest their profits for future growth. On the other hand, companies may not pay a dividend because they could be under financial stress.
Investors should scrutinise the income statement as well as pay close attention to the company’s assets and liabilities to gain an understanding of a company’s financial position.
A company may tick all the right boxes with regards to profitability, earnings growth, PE, PEG, and dividend yield but if it is over-indebted and at risk of financial distress it may be a poor investment.
Key measures of financial health include a company’s debt to equity ratio which is a company’s debt less cash as a percentage of shareholder’s equity.
When compared to the income statement the current ratio is a more immediate guide as it measures current assets (convertible into cash within 12 months) divided by current liabilities (with a maturity of 12 months or less).
The quick ratio is an even more immediate measure of financial stability, similar to the current ratio but excludes inventories from the current assets.
A company’s book value is its total assets minus intangible assets and liabilities.
A share trading at a discount to book value may be attractive even if the company is not performing efficiently or growing strongly, as investors would receive more than their investment back if the company were acquired or liquidated.
This guide is by no means exhaustive and does not provide a means for investment at home. It merely offers a taste of some of the measures and the rigorous process involved in making investment decisions.
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