Highlights in this issue:

*** There are so many tools out there, it’s hard to know which one works best…
*** Always base decisions on the PE of a share? Here’s what you’re doing wrong…
*** Worried about a company’s survival – this is the one thing you shouldn’t overlook …

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From the pen of Karin Iten

Dear Investment Academy Reader,

If you’re starting out – or aren’t clued up on the lingo – investing can be mind-boggling. For example, deciding which ratios to use on different sectors can seem daunting. But don’t be put off. We’re here to help.

And that’s why I’ve asked MoneyWeek strategist Cris Sholto Heaton to guide us through the most widely quoted ratios and how to use them in your investment decisions.

Over to you Cris…

How to avoid “woolly” ratios from affecting your investment decisions

Investors usually start with this measure of the current share price, say R25, compared to one year’s earnings per share, say R5, to give a ratio of 5. It’s a useful measure of whether a share’s cheap (a low PE) or expensive (a high PE). But watch out for the traps...

Earnings per share, on the other hand, often includes noncash items such as paper gains from the sale of property or shares. So by relying on a high PE in isolation, you may be overpaying for non-recurring earnings. Also beware of volatile profits. If you are analysing cyclicals, such as chemical or mining companies, you need to think about where they are in the cycle. A miner may look cheap on a PE of 10, but the earnings used may be the peak earnings that are set to slump. Equally, a high PE of say 50 may not always be expensive because earnings are depressed now but will rebound. Sectors such as consumer staples have fairly steady earnings, so PEs will vary much less.

A handy ratio to look at alongside the PE, especially for growth shares, is the PEG ratio – the PE ratio divided by the forecast yearly earnings growth, typically over the next five years. A firm with a PEG of 1 is often said to be “fairly valued”. While extremely crude, this is a reasonable rule of thumb for shares expecting double-digit growth. For low growth shares, however, the PEG is largely meaningless.

Investing by the book

Another widely quoted ratio is the price/book (p/b) ratio. Book value (also known as net asset value or shareholders’ equity) means the value of the company’s balance-sheet assets less its liabilities. In theory, a firm with a p/b of less than 1 is a bargain! It’s selling for less than the net value of its assets. Unfortunately, reality is a bit more complex. First, there’s the question of what the firm’s assets are really worth.

For example, p/b is often used on property companies where a p/b of, say, 0.5 might look like a bargain. But if the book value relates to property prices at the top of a bubble, the stock may be one to avoid. The ratio also falls down when firms carry high levels of intangible assets such as brands, so the p/b is generally useless for firms that lack physical assets.

What’s more, unless you’re concerned with the break-up value of a firm, p/b alone doesn’t tell you much. Since earnings come from the return a firm earns on its assets, return on equity (ROE, net income divided by shareholders’ equity) is a useful addition. High ROE firms should trade on higher p/bs than low ROE firms, because they eke out more profits for shareholders from the same amount of shareholder capital. So ROE is a useful way to compare how efficient businesses are.

However, ROE can only be compared between firms in the same sector. And cyclical firms will have a much higher ROE at share price peaks than troughs. And since ROE focuses on net assets, a firm that piles on debt while interest rates are low will boost its ROE. As a result, it may look better than a less-indebted peer, but be less well placed to survive when times get tough.

So, whether looking at PE, ROE or any other ratio, you should also take the strength of a firm’s balance sheet into account. One way of doing this is the Altman Z score, which assesses the risk of a firm going bankrupt within two years. A Z score of above 3 is considered safe.

How to invest for income

The third way to think about valuation is focusing on the income the share will pay. Dividend yield is the favoured way of valuing utilities and other low-growth shares. But it’s also an important complement to the PE when assessing any industry with fairly stable cash flows, such as telecoms or healthcare. Again, sustainability is key; check how many times one year’s earnings covers the dividend (you usually want at least two times, but utilities can get away with much less). And note the yield’s of little use for small growth firms, which often don’t pay a dividend.

Beware of banks

Provided you take account of where a firm is in the economic cycle, the ratios considered so far work for most sectors. The exception is financials. Bank earnings, for example, regularly include large non-cash items, such as revaluation gains or losses on assets, provisions for bad debts or higher payouts on policies.

Many investors use p/b for financials, but to be thorough you also need to consider a number of industry-specific measures such as combined ratios (policy payouts plus expenses divided by premiums earned). In short, valuing financials is difficult; a simpler approach is to treat them as income plays and value them on the dividend yield, being careful to avoid any firms lending or expanding recklessly.

Ratios that deserve a health warning

Valuing companies that have little or nothing in the way of earnings or assets is the most difficult thing of all. But that doesn’t stop creative analysts having a go. So you‘ll sometimes see ratios such as the share price to one year’s sales (price/sales) quoted. This can be used to put a high valuation on exceptionally low-margin or unprofitable businesses. You should also avoid even woollier ratios such as the dotcom era favourites “price to eyeballs” or “price per click”.

These can support lofty share valuations for firms that have no earnings, cash flows or assets. A high number is a red flag, not a reason to buy.

Till next time…

Cris Sholto Heaton
for The Investment Academy