Investing in shares can be something of a numbers game, especially when the financial press is peppered with mention of ratios such as "dividend yield" and "earnings per share". There is no shortage of these statistics and they can be useful as a means of assessing whether a particular share offers good returns or strong growth prospects.
On this basis, ratios are worth adding to your armoury of research, though they are by no means infallible. To begin with, ratios use historical data, which is not necessarily a guide for what will happen in the future. And the source data can be open to accounting manipulation, so any insights that ratios provide should be viewed with caution.
Let's take a look at some of the key share market ratios (though this list is by no means exhaustive).
Dividend yield: Calculated by dividing the most recent dividend by the current share price and multiplying by 100 to achieve a percentage figure. Dividend yield is a measure of the regular income return (rather than capital growth) that a share is paying, which allows a comparison between different shares, and also against other asset classes. However, when the share price changes the dividend yield will also change. Indeed, if the share price crashed, the yield would soar, until the next dividend is declared if there is one.
Earnings per share (EPS): calculated by dividing the net profit of a company by the total number of shares issued. By looking at a company's EPS history, it is possible to see the growth in earnings from one year to the next; and you can compare earnings to the dividend payouts and the share price each year.
Price earnings (PE) ratio: Calculated by dividing the share price by the earnings per share. This often-quoted ratio is a way of measuring investors' expectations about a company's performance, and it is often used to describe whether an individual company, or even the share market as a whole, is "expensive", in the sense that it is overpriced.
Overall share market conditions will have a bearing on the relative PE ratios of different shares but, as a guide, a company with a PE ratio of about 16 is considered to be a growth-orientated company, meaning there's a good chance its earnings will rise. By contrast, a company with a PE ratio of less than 11 may be regarded as having less rosy prospects for earnings growth.
While the PE ratio can be useful for making comparisons between companies, this ratio generally makes more sense if the companies under review operate within the same industry (as average PEs vary between industries), and face the same overall market conditions.
Dividend cover: Calculated as EPS divided by dividend per share. This ratio shows the proportion by which a company's dividend is covered by its earnings. A figure of less than 1.0, for example, suggests the company is paying out more than it is earning. Investors should look for a figure above 1.0, which suggests the company can comfortably pay its dividends.
Net Tangible Assets (NTA): Calculated as the value of shareholders' funds (as reported in the company's balance sheet) divided by the number of issued shares. Also known as the "asset backing", this ratio can give investors an indication of what each share in a company would be worth if all the assets were liquidated and all debts were paid and the remaining proceeds were distributed to ordinary shareholders on a per share basis.
Investors sometimes use the NTA to assess the desirability of a share. If the NTA is greater than the share price, it may be that the company is undervalued potentially making it a takeover target. Conversely, if the NTA is below the share price, the market may be overvaluing the company.
For the complete story see Money Magazine's April 2007 issue. Subscribe now.