Some more Financial Ratios

Price/Earnings Ratio

What does it mean?

The Price/Earnings ratio is how much money you are paying for $1 of the company’s earnings…

.. So if a company is reporting a profit of $2 per share, and the stock is selling for $20 per share, the P/E is 10. In other words you are paying ten-times earnings.P/E Ratio = Price Per Share / Annual Earnings per Share

Comment:

A favourite tool of the contrarian is the price/earnings ratio (P/E), which is calculated by dividing the current share price in cents by the company’s earnings per share, or EPS. Thankfully, the historic P/E on stocks is readily available, so you don’t have to manually do this calculation yourself.

The P/E ratio is rather useless on its own, but is a handy comparison tool. You can use it to compare one company against its peers, to the overall market, or sector, as well as to track historic performance.

Let’s say that one company (Company A) has a P/E of 12 and another company in the same industry (Company B) sports a P/E of 20. For every $1 of current earnings, the investor is effectively paying $12 a share for Company A and $20 a share for Company B.

It’s clear that Company A is cheaper than Company B because for every $1 of earnings, you’re paying $12 a share instead of $20.

Contrarian investors use this as a guide for finding stocks that are going cheap. They particularly like stocks that are trading on a low P/E relative to their peers and the overall market.

But does that mean that Company A is a better buy than Company B?

As we all know, earnings are the basic ingredients of share price growth, and the best stocks to buy are those exhibiting a trend of increasing earnings (we like to see earnings growth for five years or longer). Remember, earnings refer to “net profits” and not revenue.

When investors spot a company with a trend of increasing earnings, they get excited and buy shares. As more shares are purchased, the share price is bid up, and so is the P/E ratio (since the current share price is the numerator in the ratio). The more popular the stock, the higher its P/E.

So Company B could in fact be a better buy than Company A if its earnings are growing at a faster pace.

There are times however when markets get out of wack. External shocks such as the recent financial crisis send share prices into a spin, and stocks that were once expensive (on a P/E) basis can be suddenly looking pretty darn cheap.

It’s times like these that contrarian or value investors come to the fore. With their toolkit in hand, bargain hunters set to work.

A bargain means that you are getting something that should cost $10, for $5. You buy a leather couch on special for $2,000 that a week prior was holding a price tag of $4,000. This is what most of us call a true bargain without thinking too much about it.

But just because the coach was priced at $4,000 the week prior, doesn’t necessarily mean that it’s a bargain at $2,000. (It could be old stock, its design could be going out of fashion).

Likewise, just because your favourite stock was trading at a P/E of 10 many months ago, doesn’t necessarily mean that it’s a steal at 6 today. Basically you have to consider whether the fundamentals have changed.

For example, as consumers tighten their purse strings, will the company struggle to sell its goods and services? If the company has a lot of debt on its books, will it battle to get funding? If it’s an importing company, will the fall in the AUD/USD impact its sales?

Sometimes a fall in the P/E can be justified, sometimes not. And getting this right is the true test of whether a contrarian investor spots a bargain or not.

Current Ratio

What does it mean?

The current ratio is a liquidity ratio. Liquidity ratios look at the relationship between what a company owes right now – its current liabilities – and what it owns right now – its current assets.

Current assets include cash instruments, marketable securities, inventory, and accounts receivables.The formula for the Current Ratio is as follows:

Current Assets / Current Liabilities

Comment:

With liquidity ratios, higher numbers represent safer financial cushions against economic shocks. A company with a high current ratio should have no trouble meeting its short-term debt obligations without sacrificing operational capability.

However, taking the Current Ratio at face value without considering the nature of the company’s assets can lead to trouble. This ratio assumes an easy conversion of an asset into cash, which is not always the case. You need to know how quickly the company collects its receivables and how frequently it turns its inventory.

In summary, few things can drive an investment into the ground quicker than the company’s debt and its ability to manage debt. While they do not provide a magical answer, Liquidity Ratios can help you identify shares that pose less risk.

Market valuation ratios

What does it mean?

Market valuation ratios are the favored analytical tool of many investors because they use a real value that cannot be manipulated – the market price per share. All these ratios use the price market participants are willing to pay compared to other company indicators – earnings per share, expected growth, book value, and total sales.

Comment:

To give you a working example, ere are the numbers for two stocks in the biotech sector (as at 29th May 2011):

  SRX CSL Sector
Price to Earnings (P/E)

25.31

19.2

14.8

Price to Earnings Growth (PEG)

10

2.06

10

Price to Book (P/B)

5.65

4.42

2.03

Price to Sales (P/S)

4.51

2.24

8.57

The P/E ratio for SRX tells us the market sees this company as a growth share. While value-oriented investors would say it is overpriced, the fact is, there are sufficient market participants willing to pay more for these shares. Their Price to Book is also higher than the sector average, again indicating the willingness of market participants to pay a higher price for the shares than its raw fundamentals might warrant.

Although the PEG ratio for SRX is quite high, it is right in line with the sector average. High PEGs are indicators of a potentially overvalued share.

The numbers here tell a clear story. The market is expecting high growth from Sirtex Medical and is willing to pay a premium price for the privilege of going along for the upward ride.

www.thebull.com.au

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