In this article, we will analyse some of the key basic investment ratios to measure shares' performance. For somebody whose knowledge about shares is limited, we would highly recommend reading our previous articles: Shares: An Introduction to Company Law or The Impact of Corporate Actions. You may also be interested in learning more about the UK Financial System.
The price of shares is driven by supply and demand. The number of shares (supply) is generally constant unless the company decides to issue a new tranche of shares, while the demand for them is hugely affected by various factors. A period of prosperity and economic growth may increase investors' appetite to buy shares, while an uncertain political and economic climate may discourage investors in an equity's trading. A company's share price is also likely to reflect if the company is well-managed or not or how profitable it is. A constantly thriving company with a talented management team and raising profits will attract more interest from investors than a firm with crippling debt whose profitability and financial strength do not produce a promising future outlook. Different investment ratios enable investors to compare the performance and value of shares against each other or against other types of investment (The Chartered Institute for Securities & Investment, 2020).
Enterprise Value (EV)
Enterprise value is often used as the theoretical measure for the cost of a potential takeover. It reflects the entire business's market value after taking into account holders of debt and equity. Also known as total enterprise value, EV tells us how much a business is worth (Fin-Wiser Advisory, n.d.).
EV= Market capitalisation + Total Debt – Cash - Cash Equivalents
Net Asset Value (NAV) Per Share
Net asset value (NAV), also known as the book value, is the total assets of a company minus all its liabilities (Arnold, 2020). If the company goes into liquidation, the NAV may be a useful measure to establish the amount available for shareholders once all other claims have been met. NAV is vital for investors in investment trust (CISI, 2020) or commonly used in relation to mutual funds to determine the value of the assets held (Corporate Finance Institute, n.d.).
The NAV, however, is typically represented on a per-share basis. We can calculate the NAV per share using the following equation:
Earnings Per Share (EPS)
Earnings per share (EPS) is considered the single most popular, widely used financial performance benchmark (de Wet, 2013). EPS is also used to calculate the price/earnings (P/E) ratio, which is another measure to evaluate shares' performance. To stay competitive, companies must ensure that part of their growth and expansion is financed from retained earnings. Therefore, the EPS is often used by analysts and investors to evaluate companies' performance, to predict future earnings, or to estimate the value of the company's shares (CFI, n.d.). Not all of the company's profits are distributed to investors in dividends. This measure also helps to determine if the company is likely to distribute stable or rising dividends in the future. The higher the EPS, the more profitable the company is considered to be, and the more profits are available for distribution to its shareholders. There are two types of earnings per share: basic and diluted. The former shows how much of the company's earnings are attributable to each common share. The latter represents the number of the company's earnings attributable to each common shareholder in a hypothetical scenario in which all dilutive securities are converted to common shares (CFI, n.d.). Therefore, the basic EPS is always larger than diluted EPS, which includes options, convertible securities, and warrants outstanding that can affect total shares outstanding when exercised.
The basic EPS attributable to each equity share can be calculated as follows:
Weighted average shares outstanding refers to the number of shares of a company calculated after adjusting for changes in the share capital over a reporting period (CFI, n.d.).
It is also possible to calculate the earnings yield, which is inverse to the P/E ratio. The formula is as follows:
Price/Earnings (P/E) Ratio
The P/E ratio compares a company’s share price with its latest annual earnings per share.
This measure plays a pivotal role in both academic research and investment practices, and it has been found to reflect the market’s expectation of future growth and is associated with firm risk (Zarowin, 1990; Thomas & Zhang, 2006; Wu, 2013). The Chartered Institute for Securities & Investment provides some of the key reasons why investors find the P/E ratio a useful tool in equity security analysis (see Figure 1).
Figure 1. The main reasons for using the P/E ratio. Source: The CISI (2020).
The P/E ratio receives the most attention from the press, and it is often quoted in financial articles. The measure changes daily as the market price of shares is likely to change every day. Generally, the higher than average P/E ratio, the better. Sometimes the lower P/E ratio than an average for its sector may indicate that a company’s shares can have an upward correction in its price, given the market expects its profits to improve in the future (CISI, 2020). On the other hand, a low P/E ratio may indicate a company is in financial difficulties. Arnold (2020) suggests that companies with a high P/E ratio are not necessarily expected to perform to a high standard in the future and that the measure provides historical figures.
Gross Dividend Yield
The dividend yield is another historical measure. The Chartered Institute for Securities & Investment defines it as the ongoing distribution of profits investors receive from a company. At the same time, the yield is simply the income earned by the investor on their holdings as a percentage of the prevailing share price. The gross dividend yield measure is a useful tool in comparing companies’ equity shares traded in the same sector or industry or even against different financial instruments, such as Government bonds. Arnold (2020) provides a relationship of dividend yields relative to the performance of shares:
‘‘Those companies expected to grow their profits at a faster rate will have low dividend yields because investors tend to bid up the share price. These lower yield share are often labelled ‘growth shares’. Higher yield (or simply yield) stocks are expected to have low profit growths and are labelled ‘value shares’.’’
Dividend Cover
Dividend cover is the ratio of profit attributable to ordinary shareholders to dividends (Arnold, 2020). To obtain the dividend cover, the EPS is simply divided by the amount of dividend per share paid out to a shareholder. This measure can be used as a way of showing the number of times that the dividend could theoretically have been paid out to shareholders from available profits (CISI, 2020). The higher the dividend cover, the safer dividends are because it can indicate that a company has plenty of money to pay their dividends.
Gearing Ratio
Gearing, also known as financial leverage, is the financial ratio of a company’s long-term debt to its equity capital. A business with high gearing, the one that is mainly funded by loan capital (borrowings), is more likely to be vulnerable in times when interest rates rise. In this case, a company may struggle to find the cash to keep up with interest payments. Share capital and borrowings are both needed to run a business successfully. However, the right balance must be maintained (depending on the company’s policy and the nature of its business). Otherwise, when times are bad and profits are poor, a company may suffer disproportionately high downturns in profits, possibly leading to insolvency.
Capital employed (total assets minus current liabilities) refers to the amount of capital investment a business uses to operate and provides an indication of how a company is investing its money. An alternative version of the gearing ratio is the times interest earned ratio (CISI, 2020).
Price-to-Cash Flow (P/CF) Ratio
It is a similar measure to the P/E ratio. However, it utilises the cash flow instead of earnings. This way, the effects of depreciation and other non-cash items are removed. According to the Chartered Institute for Securities & Investment, the price-to-cash-flow (P/CF) ratio may be used to determine whether a firm is overvalued or undervalued. A low P/CF may be desirable if further investigation suggests that the firm's price is low when compared to its cash flows. On the other hand, a high P/CF may suggest the firm is not generating enough cash flow. Besides, high P/CF ratios are common for companies in their early stages of development when the share price is mostly valued based on their future growth prospects while a small amount of cash is generated (Corporate Finance Institute, n.d.).
Price-to-Book (P/B) Ratio
The price-to-book ratio (P/B) compares the market value of a company’s stock to its book value, i.e., the value remaining after all assets are liquidated and liabilities settled. This measure is predominantly used when analysing the banking sector. Again, this ratio can be used as a way to determine whether a firm is over- or undervalued.
Bibliography
Arnold, G. (2020). The Financial Times Guide to Investing. 4th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1365862/
The Chartered Institute for Securities & Investment (2020). Investment, Risk & Taxation. 11th edition. CISI: London
Corporate Finance Institute (n.d.). Finance Articles [online] . Available at: https://corporatefinanceinstitute.com/resources/knowledge/finance/