How do you know if a stock is a good value?

There’s no way around it, you need to do some homework and math if you’re thinking about buying stocks.

But which sums are most useful to investors when weighing a stock? And how do you locate the figures you need in a company’s financial reports?

Sheridan Admans, head of fund selection at investment platform Tillit, walks us through some basic arithmetic that will tell whether a company is undervalued or overvalued and whether its financials are sound.

Price Earnings or PE Ratio

Price divided by earnings per share

A company’s PE ratio should be evaluated relative to the PE of the broader sector; This indicates how a company is performing relative to its peer group. But as a general rule, a high PE indicates that there is a higher risk.

Company PE ratios are easy to calculate yourself and you can find them on most good stock lists on online market dataFor example, These are the individual Money sharing pages, like this for BP stockshows the PE ratios.

FTSE sector PEs can be harder to come by unless you are a professional investor, but you can try to locate them online for free. Alternatively, a subscription-based stock information service, such as Stockopedia – which This is Money recommends for serious stock investors, shows PEs compared to industry/sector levels.

It is useful to compare a company’s PE ratio with that of its industry. “Doing a comparison gives you an idea of ​​whether it’s below or above the industry average,” says Sheridan Admans of The Share Centre.

‘Below the sector average and it is undervalued or there is a problem.

‘Then you start looking for which one it is.

“If it’s above average, it’s overvalued or something has changed in the business, a change in its ability to grow revenue.”

To find answers, look at the business review section of an annual report to see what the company has been doing and what it intends to do in the future, Admans says.

And to be more comprehensive, he suggests re-reading business reviews from recent years to see what your ambitions were then and how successfully you’ve fulfilled them.

He urges investors to pay close attention to the management structure, particularly any changes to the board. If there are new appointments, read their CVs.

According to Admans, the business review is where you really get a feel for the business.

He says you then have to ask whether the current valuation is sustainable, whether management is doing enough to support a higher valuation, and whether the company has a credible plan that can realistically be achieved.

One reason to analyze sectoral PEs is that the norm varies widely across industries. For example, Admans notes that technology companies tend to have much higher PE ratios than those in the manufacturing sector.

A manufacturer with a PE of 80 would send investors fleeing, but technology companies typically have PEs between 50 and 80.

“They can grow profits faster and expand across regions and continents faster than a widget maker,” Admans explains.

“You have to understand the company and ask yourself if that valuation is justified.”

Return on capital

Net income divided by shareholders’ equity

Return on equity will tell you how efficient a company is with equity capital, Admans says.

‘It measures the profitability of the company with the money that shareholders have invested. The higher it is, the better. And what we want is for it to be sustainable.”

He says it will be necessary to go back and calculate the return on capital over several years. If it is consistent, that shows stability, but if it has gone up and down, it indicates that there has been some source of instability.

This could be the economic environment, launching a new business or investing overseas, and you should do some research to find out.

“You need to gather all the information and ultimately make an opinion,” says Admans.

Interest coverage

Earnings before interest and taxes (EBIT) divided by interest expense

Interest coverage tells you whether a company can meet the interest payments on its debt.

‘If not, do you want to invest in them? Eventually a problem will arise,” says Admans.

It says that you seek reassurance from any figure greater than 1 and preferably greater than 1.5.

Anything below or around 1 should raise alarm bells about whether a company will be able to keep up with interest payments.

Dividend coverage

Earnings per share divided by total annual dividend

‘Is your dividend covered? If not, that means you are leaving capital. At some point the dividend will be reduced or disappear completely,” says Admans.

If a company cuts its dividend, income investors and income funds will pull out of the stock.

“At some point it will have a significant impact on the stock price and your personal wealth,” Admans warns.

On the other hand, a company that consistently increases dividends can generate great returns, especially if it continues to reinvest them in more shares.

Many companies have a dividend policy, which could be, for example, that payments to shareholders are broadly covered twice by profits, so find out what this is and consider the likelihood that management will adhere to it. .

Current relationship

Current assets divided by current liabilities

This is a liquidity ratio that measures the company’s ability to meet its short-term obligations, explains Admans.

“A ratio less than 1 suggests that the company would not be able to meet its obligations if they fell due at that time,” he says.

“This does not necessarily mean that you will go bankrupt, as there are many ways to access financing.”

‘It provides an idea of ​​the company’s efficiency and its ability to convert products into cash.

However, it is worth remembering that operations in each industry differ, so it is useful to compare companies within your same sector or industry.’