6 key numbers to size-up a stock

Highlights in this issue:

*** What actually is the p/e ratio...?
*** Why you should be looking at the dividend...
*** How to put the odds back on your side... and more...

From the overworked laptop of Julie Brownlee...

Dear Investment Academy Reader,

The sheer volume of financial information produced by firms can baffle a first-time investor. But you can cut through a lot of the data by using a few key numbers to gain a snapshot of the group's performance, which should reveal whether a share is worth buying or investigating further.

1. Price/earnings ratio

The best starting point is the price/earnings (p/e) ratio, which divides the latest share price by earnings per share (EPS, found at the foot of the profit and loss account). If the current share price is R100 and EPS is R10, the p/e ratio is ten. In effect, it'll take you ten years to make back your money if earnings remain exactly the same. The ratio is one way of judging whether a share is cheap or expensive - the higher the number, the more you're paying for the earnings a firm is generating. Whether or not it makes sense to buy a share on a p/e of ten depends on how this compares to competitors in the sector and the company's own earnings growth rate.

2. Price/earnings to growth ratio

That's where the price/earnings to growth (PEG) ratio comes in. Obviously, a firm's earnings aren't constant from year to year and, in normal circumstances, the faster profits are growing, the more you'll be willing to pay for future earnings. So if a firm's p/e ratio is low compared to its expected growth rate, it's worth a second look. For example, if a firm has enjoyed earnings growth of 15%, and you can pick it up on a p/e of ten, the PEG is only 0.67 - anything below one is considered cheap. Be wary of shares where the p/e ratio is more than twice the earnings growth rate.

3. Dividend yield

Dividends are often overlooked in the scramble to find the next shares that might double or triple in price, but they're absolutely vital to successful investing. The dividend yield shows the dividend as a percentage of the current share price, which makes it easier to compare both to yields on other stocks and income investments such as bonds. A good yield is attractive as it gives as it gives a regular income stream from your investment, which means you rely less heavily on future share price growth. To find out the best dividend payers on the JSE, just click here.

4. Dividend cover

Cover looks at the number of times a firm's profit available to shareholders covers the ordinary dividend, information that's available in the profit and loss account. The higher, the better, as it increases the likelihood that this year's dividend can be repeated. For a sound night's sleep, cover at least 1.5 times is adequate - two or more is idea, but can be difficult to find.

5. Gearing and interest cover

Gearing, or "leverage" in the US, is the relationship between all short-term and long-term balance sheet debt (i.e. what the company owes its lenders) and shareholders' funds, or "equity" (the amount contributed by its owners). Just as a large mortgage relative to income will stretch a homeowner, so high gearing is a reliable indicator of balance sheet risk. For example, if a company has borrowed R50 million and has shareholder funding of R150 million, its gearing ratio is 33%, making it more vulnerable in times of trouble than a company with a ratio of only 10%. In fairness, a gearing ratio in isolation isn't very useful, since firms in certain sectors, such as construction, tend to borrow more heavily than others, such as those in software. So seek out stocks that have low gearing relative to their peers.

Also, just as a mortgage lender will consider whether you can meet your mortgage payments from income, so an investor should consider how well a company can cover its interest payments. Do this by capturing profit before interest as a multiple of the interest charge in the profit and loss account. To attract the highest AAA safety rating from a credit rating agency, such as Standard and Poor's or Moody's, a company would normally be expected to over its interest charges at least ten times.

6. The price to book ratio

This ratio compares the stock market price of a share with the asset book value per share from the accounts. Say a company has R100 million in assets on the balance sheet and R75 million in liabilities. The book value of that firm would be R25 million. If there are ten million ordinary shares outstanding, each represents R2.50 of book value. If the share price is R5, then the price to book (P/B) ratio is two (5/2.50). At less than one, the shares can be a bargain (you can basically buy the company's assets at a discount), but at two or above there is a risk of overpaying.

This ratio is most useful when looking at firms with a high tangible asset base, such as investment trusts or property firms, but less reliable for those that are earnings driven, highly geared, or have most of their value tied up in intangible assets. Thus, whereas a software firm such as Microsoft might change hands on a P/B of ten or more, this would be unaccceptable for a property company. 

Happy trading!

Julie Brownlee
for The Investment Academy

** This article was adapted from a piece in MoneyWeek magazine