The secret to successful investing is surely identifying the best companies that show the most potential, right? I wish. Paying a good price is equally important: after all, there is often no point in buying a top-tier company if it is so expensive that its share price will never rise.
However, calculating a company’s value is not that simple. It can be based on how its price compares to similar companies, whether its value is likely to increase, or what it is likely to pay out to shareholders in the form of dividends, for example.
We asked fund managers to give us the general rules or formulas they apply to companies to assess whether they are worth investing in or whether they are best avoided.
Here, Wealth investigates some of its most popular “magic numbers” and how you can use them to decide where to invest your money.
Wealth investigates the most popular “magic numbers” of some fund managers and how you can use them to decide where to invest your money
1. PRICE/BENEFITS RATIO
What it is: This shows how much a company is worth on the stock market compared to what its shareholders earn.
How it is calculated: Divide the stock price by the company’s earnings per share for the full year, which are available in its published financial statements. The price-to-earnings ratio, also known as the P/E ratio, is expressed as a multiple. So, you might say a company has “five times earnings” or “one hundred times earnings.”
Published financial statements only reveal what a company has achieved in the recent past. Some investors choose to do the same calculation with estimated earnings for the current year. This will result in what is called a “forward price-earnings ratio.” However, since these figures are only predictions, there is no guarantee that they will turn out to be correct.
Because it is important: Fund manager Eric Burns, who runs the Sanford DeLand Free Spirit Fund, says the price-to-earnings ratio provides a “quick gauge” to show how cheap or expensive a stock is relative to similar stocks in the same industry. At first glance, a stock with a price-to-earnings ratio of three looks much cheaper than one with a price-to-earnings ratio of ten.
You can also use it to see if a stock is cheaper or more expensive than it has been historically compared to its earnings, by looking at how the price/earnings ratio changes over time.
But beware: According to Jamie Mills O’Brien, chief investment officer at financial group Abrdn, such valuations are a shorthand way of saying things, but they have limitations.
The price/earnings ratio shows how much the stock market values a company compared to what it earns for its shareholders.
Price/earnings ratios do not show how a company is growing or whether it has special features that should allow it to grow over long periods.
For example, investors interested in Novo Nordisk, which makes the weight-loss drug Ozempic, may have dismissed the company in the 2000s as too expensive due to its high price-to-earnings ratio. However, it has continued to experience such growth due to the patents it holds that it would still have been a good investment.
“The reality is that an investor could have paid a price-earnings multiple of over 100 for Novo Nordisk in 2005 and still gotten a double-digit percentage annualized return,” says Mills O’Brien.
Burns warns against buying companies that are simply cheap without doing further research.
“There is no point in buying a company that is trading on a price-earnings ratio of two, for example, if it is up to its neck in debt and will not be around in a year,” he says. “You should not confuse cheap with good value.”
2. PRICE/SALES RELATIONSHIP
What it is: A similar way to value a company is the price/earnings ratio, also expressed as a multiple, but it uses sales figures instead of profits.
How it is calculated: Divide a company’s market capitalization, which is the number of shares multiplied by the price per share, by its total sales over the past 12 months.
Because it is important: Like the price-earnings ratio, it shows how much the stock market values a company compared to its performance, but some fund managers say it’s more accurate to look at sales rather than past earnings when predicting future performance. “You can’t lie about sales,” says fund manager Richard de Lisle, who runs the De Lisle America Fund.
He says that traditionally, a good level to buy was if the price-to-sales ratio was below 0.7 – in other words, sales were at least 1.5 times the company’s market cap.
But beware: De Lisle says the performance of tech startups in recent years has been a game-changer and price-to-sales ratios are not always a good predictor of future growth.
Companies like Microsoft, Facebook owner Meta, and Google parent Alphabet have high price-to-sales ratios, but they have royalties that allow them to enjoy strong sales for years.
3. DIVIDEND YIELD
What it is: Companies often return part of their profits to investors in the form of a regular cash payment – or dividend – per share several times a year.
A stock’s dividend yield is expressed as a percentage and represents the amount of money a company pays out in dividends compared to its share price.
How it is calculated: Find a company’s full-year dividend paid per share (you can find this in its financial statements) and then divide it by the share price. Alternatively, you can use an estimate of future dividend payments (analysts make these forecasts) to calculate a forward dividend yield.
However, there is no guarantee that it is accurate.
Companies often return part of their profits to investors in the form of a regular cash payment (or dividend) per share several times a year.
Because it is important: The dividend yield shows how much money you make for each year you own a stock. A healthy dividend yield can also indicate that a company is performing well enough financially to make a profit and reward its investors.
But beware: Companies can stop paying dividends abruptly.
Paying a lot of dividends is not always a sign that a company will also increase in value. De Lisle warns that good returns are often a sign that companies cannot do much more with their money to generate more profits for shareholders. “Sometimes good returns are in boring sectors where there may not be much growth,” he says.
4. PEG RATIO (PRICE/EARNINGS/GROWTH)
What it is: The PEG ratio attempts to factor a company’s growth potential into the equation, not just current earnings.
How it is calculated: Take the price/earnings ratio calculated above and divide it by the earnings per share growth rate.
In most cases, you should use the expected growth rate between the last published earnings per share figure and the estimate for the next year, although some people use historical figures or even five-year estimates.
Because it is important: Fast-growing companies typically have higher price/earnings ratios than slower-growing ones, but this can make them appear unfairly expensive.
However, adding their growth rates to the mix may give a fairer comparison.
Sam North, an analyst at investment platform eToro, says the move allows for potential.
“As a general rule, a PEG ratio of 1.0 or below indicates that a stock is fairly priced or even undervalued. A PEG ratio above 1.0 indicates that a stock is overvalued,” he says.
But beware: Analysts can use many different numbers to calculate the PEG ratio, and the estimates are not always correct.
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