Key numbers to assess when buying a stock include:
- Price to earnings
- Dividend yield
- Earnings per share growth
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 in the ratios which compare a firm’s revenue to its worth. 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) are 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 used PE which analysts use 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 could 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)
Debt to Equity 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 riskier, while a lower leverage ratio indicates 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 in what EPS is for the current year in question, but also what level EPS will be in the preceding year. For example, we may know that while a company may experience low profitability in 2019, it will be temporary and in 2020 profits are set to grow strongly. These considerations will be kept in mind by investors and reflected in share prices.