Finance for the faint-hearted: disentangling financial ratios

You don’t ‘get’ all those numbers? You’re not alone: plenty of other investors don’t ‘get’ them either. Don’t be put off: they’re more understandable than you might think.

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Inexperienced investors can often find researching a prospective investment to be a daunting process.

They’ll go to a data source — often their own broker or investment platform, or one of the specialist finance sites, such as Google Finance, or Yahoo! Finance — and quickly be baffled by the bewildering array of data displayed.

So many numbers! And what do they all mean?

Most people ‘get’ yield. It’s simply the dividend, in pence, over the current share price. 5p dividend; 100p share price; 5% yield. Frequently, people think of it as akin to an interest rate. It’s not, of course, but the approximation can be helpful.

But earnings per share? Price-to-earnings ratios — often abbreviated to “P/E ratio”? Altogether more problematic. And so on, and so on.

Understandably, when faced with numbers and ratios that they don’t understand, it’s easy for people to be put off the whole idea of investing.

Nuggets of gold

As a result, I often point inexperienced investors to companies’ annual reports. They’re chunky documents, with pages and pages of financial statements and accounts. But that’s not what I’m urging people to read.

Nor is it the chairman’s annual report, or the chief executive’s report.

Nor is it the glossy photographs illustrating whatever it is the company does, or the frequently found map showing the geographic spread of the company’s operations, and its scale — although you’d be amazed at how little some prospective investors can understand of these.

Instead, it’s a handy one or two pages of simple financial charts and key performance indicators, often found on or around page five or so. A page of pure gold, for the initiated.

These charts, if you understand them, tell you an awful lot about a company — and can help point you to prospective bargains. Or, on the other hand, companies that might be best avoided.

What’s the story?

Now, let’s be clear. These one or two pages of financial charts and key performance indicators don’t follow any particular order or format. There’s nothing officially laid down about that.

And you’ll notice that I’m saying “financial charts and key performance indicators” — and those key performance indicators are usually highly dependent on the nature of a company’s business. A property company might show lease durations, for instance, while a housebuilder might show new house sales, or building starts, or the size of its ‘land bank’.

But whatever the metric, there’s often a five-year bar chart, or similar prior-year comparison. And they can tell you a lot.

Are sales revenues going up, or down, or are they flat? What about profits? And are profits growing faster than sales revenues, or slower — or about the same? What about those industry-specific key performance indicators: what do they tell you about the state of the business?

In short, that page of simple charts and metrics can tell you an awful lot.

Building on the basics

But what about metrics such as the price-to-earnings (P/E) ratio, and earnings per share?

Now, let’s be clear: you will usually find earnings per share on the page of charts; you won’t find the P/E ratio. That’s because the ‘price’ part is the share price, and that varies not only daily, but during the day as well. So annual reports don’t quote it, but finance sites and investment platforms do.

Earning per share is straightforward: take the company’s after-tax profits, and divide them by the number of shares in existence. You’ll also often see ‘adjusted’ earnings per share figures (in which earnings or losses relating to non-core activities are stripped out), and ‘diluted’ earnings per share, which adjusts for the impact of share options and so forth.

Those earnings aren’t the same as the dividends that you’ll receive, of course — some profits have to be reinvested in the business — but an earnings per share figure that is growing, and which comfortably exceeds the dividend per share, is a sign of a share where the dividend looks reasonably secure.

P/E ratio

And the P/E ratio? This, essentially, is a measure of whether a company is cheap or expensive. Take the company’s share price, and divide by the earnings per share — in effect telling you how many years you’d have to hold the shares for the company’s profits to notionally re-pay the price you’ve paid for the shares.

Share price 100p; earnings per share 10p; P/E of 10. Simple: a 10-year ‘payback’ (although earnings, to stress, aren’t the same as dividends).

On its own, that’s not hugely useful, beyond simple rules-of-thumb such as “a low P/E is potentially more attractive than a high P/E”. And even then, there are caveats: is that P/E low because the ‘P’ part of the ratio indicated a gloomy market prognosis, for instance? But all things being equal, a low P/E is better than high.

What you’re really looking for, though, is a low-ish P/E where the earnings per share are growing, and growing quickly. Given decent growth, that 10-year ‘payback’, for instance, might be seven — or even five. An attractive prospect, and a potential bargain hiding in plain sight.

Doing it for real

Baffled by earnings per share figures and P/E ratios? Hopefully no more!

So start putting it into practice…

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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