Three financial ratios for picking stocks
In Part 3 of our course, we mentioned that there are certain indicators that show whether a stock/share represents good value or not. We decided to publish this post to give a little more detail about these indicators work for users who wanted to dig deeper into these. As usual, we’re required to point out that none of this information is professional investment advice.
The Price-to-Earnings Ratio:
This is calculated by dividing the current share price by the company’s earnings per share. Earnings per share is calculated by dividing the year’s profits by the number of shares in circulation. All this information can easily be found online on Google Finance or Bloomberg. A Price-to-Earnings ratio of 15 means that a stock’s price is 15 times the amount of profit attributed to that company each year. It’s important not to Generally, a P/E ratio of below 15 is considered good value while above 15 starts to get expensive.
However, a some sectors have lower average P/Es than others, so it is important to compare a company’s P/E with others in a similar industry. Typically, house builders have P/Es of less than 10, while tech companies can often have P/Es well over 100. However, if a company has a low P/E, meaning that it’s share price is low compared to its earnings, this could mean that the company’s profits are expected to be low for the coming year. Therefore, it’s important to investigate and do your research before making investment decisions.
The Dividend Yield:
We touched on dividends earlier. Shares often also pay a dividend, which means that a share of that year’s earnings-per-share is paid out to shareholders. The dividend yield is last year’s dividend expressed as a percentage of the current share price. So, for example: Company X’s shares are worth 100p each and last year the company paid a dividend of 5p. Therefore 5p/100p means that the dividend yield is 5%, which is actually above the FTSE 100 average of 4.4%.
However, since the dividend yield uses last year’s figures, you should check that the current year’s dividend is expected to be roughly the same, or higher. It is rare for a company to pay a dividend that is above 8%. Often, if you see a yield of around 8-12%, this is likely to be because people think that the company is going to do badly meaning that the share price is low relative to last year’s dividend. Once again, you need to research the stock and make sure that the company will pay a similar dividend in the current year and in the future.
Free Cash Flow:
This is a little trickier to define. Profits are not the same as “cash flow”. When a company makes a profit, it will have to reinvest some of that money into the business, which is called capital expenditure, use it to pay off debts and off course pay a dividend. Free cash flow is the amount of money left over once money comes in and capital expenditure is paid. If a company has high free cash flow, it likely has a growing cash balance. This can be found on a company’s cash flow statement, which will be available online.
These are just a few things a value investor might look for when picking a stock.