The share market is full of metrics and acronyms. Terms like ROE, ICR, and EPS can be confusing and even intimidating for retail investors. But with our simple guide, you can master these metrics and use them to your advantage.
EPS
EPS refers to a company's earnings per share. Earnings per share are calculated by dividing a company's profit by the number of ordinary shares it has on issue. The EPS indicates how much investors are willing to pay for each dollar of a company's earnings. The higher the EPS, the more profitable a company is.
When calculating EPS, a company's profit should be adjusted downward for any dividends paid on preferred shares during the period. Similarly, the number of shares must be adjusted for any shares that were created or issued during the period in question.
The earnings used in the EPS calculation can be misleading if distorted by once-off or unusual items. For example, the sale of a significant asset may inflate profits for a particular period, but is unlikely to have an ongoing impact. Likewise, the realisation of large impairments may negatively impact profits during a period without causing on ongoing decline in profitability. For this reason, analysts may choose to exclude these 'extraordinary items' from their measure of earnings when calculating EPS.
Early stage companies and startups may have low or no earnings per share, with investors banking that earnings will flow as the company matures. Later stage companies with an established market presence and revenue streams will generally have higher earnings per share.
P/E Ratio
The price-to-earnings (P/E) ratio is the ratio of a company's share price to the company's earnings per share. Also known as the price or earnings multiple, this metric can be an indicator of whether a company is overvalued or undervalued.
P/E ratios can be useful in comparing similar companies or comparing a single company against its own historical performance. Companies that have no earnings or are losing money will not have a P/E ratio as there are no earnings to divide the price by.
Typically high growth stocks have high P/E ratios, as investors expect high rates of earnings growth in future. An example of this is WiseTech Global Ltd (ASX: WTC), which has a P/E ratio of 154. This can be compared to a company like National Australia Bank Ltd (ASX: NAB), which has a P/E ratio of 13.7
P/S Ratio
The P/S ratio refers to a company's price-to-sales ratio. It is calculated by dividing a company's total market capitalisation by its total revenue or sales. The P/S ratio indicates how much investors are willing to pay for each dollar of a company's sales.
By comparing P/S ratios across companies in the same sector, investors can get an indication of whether a company is overvalued or undervalued relative to its peers. Using the measure across industries can be more problematic as the ability to turn sales into profits can differ across sectors.
Unlike the P/E ratio, the P/S ratio does not take account of debt. It is possible for a company to make high sales and revenues without turning a profit if the costs (including interest costs) of making those sales are just as high, or even higher.
When using the P/S ratio it is important to be cognisant of potential underlying reasons for differences in valuations. These could include companies having different balance sheets, different expense profiles, and different growth prospects.
Dividend yield
A company's dividend yield is its annual dividend divided by the share price. It represents the dividend-only return on a share investment. When dividends remain the same, the dividend yield on a share will rise when the share price falls, while the yield will fall when the share price rises.
Traditionally, early stage companies and those in growth phases have tended to have low dividend yields. When companies pay out profits as dividends to shareholders, these funds cannot then be reinvested by the company to spur future growth. Mature, lower growth companies tend to pay out a higher proportion of profits to shareholders therefore have higher dividend yields.
Dividend yields are important to investors who rely on shares for income, but are not static – yields may appear attractively high due to falling share prices. Dividends can also be cut, as was recently done by Westpac Banking Corp (ASX: WBC) and NAB.
Payout ratio
A company's payout ratio shows the percentage of a company's earnings that is paid out to shareholders as dividends. It is calculated by dividing the total dividends paid over a period by the company's earnings over that period. The payout ratio can indicate how sustainable a company's dividend payments are.
A low payout ratio indicates that a company is reinvesting most of its earnings into its business to spur future growth. A high payout ratio indicates that the opposite is true; if the ratio is over 100% the company is paying more dividends than it is earning.
Different industries tend to have different payout ratios. Defensive industries with stable income flows such as telecommunications, utilities and consumer staples tend to have higher payout ratios. Industries with fluctuating cash flows or in cyclical sectors such as resources tend to have lower payout ratios.
Some companies set target payout ratios. Coles Group Ltd (ASX: COL), which operates in the consumer staples sector, has a target payout ratio of 80–90%. AGL Energy Limited (ASX: AGL), which operates in the utilities sector, has a target payout ratio of 75%.
ROE
ROE stands for return on equity. Return on equity is a way of measuring a company's profitability in relation to the money shareholders have invested. It is calculated by dividing a company's net income by shareholder equity. A high ROE indicates that the company is very efficient at generating returns using shareholder capital.
ROE can be used to compare a company to its competitors in the same industry or against the same company across different points in time. Doing so can give an indication of which companies in an industry are performing more efficiently, and of how the performance of a company changes over time.
Foolish takeaway
Used wisely, financial metrics can give useful insights into potential share market investments. Understanding how the metrics are calculated is key to unlocking their value. Trends in metrics will vary across industries and over time, but your knowledge of how to interpret the data will serve you well.
