July 3, 2011
The P/E Ratio is often used as a guide to how cheap, or dear, a company’s share price is. However, this ratio also has other uses and can be a tool to predict future share prices.
Within business school finance subjects the P/E ratio is often taught as a predictor of future share prices rather than a value gauge. The fundamental assumption underlying this prediction is a static P/E ratio over time.
With this assumption in place, the P/E ratio can be used to predict price (P) from expected, or actual, earnings per share (E). I’ll give you an example: if company XYZ has a share price of $20 and EPS of $2 in July, 2011, then its P/E ratio is 10. Now if we use the assumption that the P/E ratio (10) remains static over time and EPS rises to $4 by July, 2012, then the formula follows that the share price will rise to $40.
Now, suddenly, accurate earnings forecasts create even more opportunities because if you can correctly predict future EPS and this theory holds true, then you can correctly predict future share prices.
Whether you believe the underlying assumption holds true over time is up to you. Some academics preach it, and they have dedicated their working lives to analysing things like this. On the other hand, people like Warren Buffett tell us not to listen too much finance academics, and no one can argue about his success in the markets. I just thought I’d tell you about another way to look at the P/E ratio that is often overlooked in the mainstream financial media.
There is often a turf war between those that consider themselves technical investors and those that rely on fundamental analysis.
The reality is that both systems should coexist.
If you rely on charting and technical analysis, are you leaving yourself short without conducting any fundamental analysis?
Whether you take a long or short position in a stock, you should know something about the underlying business you are investing in. Taking a simplistic view to make a point; would it be smart to take a short position in “Great” business with strong fundamentals? Or vice versa? Although technical analysts say the “trend is your friend”, by ignoring fundamental analysis, technical investors may be in fact betting against the market, e.g. taking a short position in a business that is good fundamentally and should rise.
I am not telling anyone to throw away their charts, but I am saying that you should back up your technical positions with the fundamentals.
May 17, 2011
If you haven’t worked out already I run a website which performs online financial ratio calculations, www.ratioanalysis.net.
We have only been operating for a little over a month, but already I am seeing trends in what are the most popular financial ratios.
The group which has received the most page views is definitely the profitability ratios. This is followed by a mix of liquidity and leverage ratios.
What is this saying about DIY financial analysis? It is saying that earnings and bottom line performance is still the most important, but people are still concerned whether too much risk been taken on to achieve this performance, and whether the solvency is ever at doubt.
What I can’t yet see is who is actually using the site (we haven’t yet done this sort of research). I am not sure if it is investors, business owners or students who do the most DIY ratio analysis. Profitability ratios are common to all three groups, while investors would be most concerned about leverage and business owners possibly about liquidity.
As for definite rankings, based on unique page views, here are the top 5:
1) Profit Margin
2) Return on Assets
3) Gross Profit Percentage
4) Current Ratio
5) Debt Ratio
Thanks for your time, guys.
Most people would ardently claim that they research their investments. But often if you ask a few more pressing questions you find out they leave investment decisions to their financial adviser.
Financial advice is almost always a good thing. Don’t get me wrong, I wish more people took enough interest in their finances to get advice, but my point is that you should never take financial advice as gospel.
You do not need to know as much about investing as your financial advisor, but you should know enough to confirm whether you are getting good advice. Like any profession, there are good and less good practitioners and only your own knowledge allows you to differentiate between the two.
For starters, do you know basic performance measures of the recommended investment. Do you know where to begin looking to conduct research? Does this investment match your risk profile? Again, I don’t want to put down financial advice, but these are the type of questions you can ask an adviser, rather than just ask “what should I invest in?” while leaving the final decision to them.
Unless your adviser is hiding something, or possibly bloated by their own ego, I’m sure your advisor would be excited by the prospect of having a more active and knowledgable client. They would welcome you conducting your own research both in the interest of building trust in their advice, and in their own self-interest in the fact that you may make more investments through them.
So get out there and do your own homework! You don’t have to become an expert, but it shouldn’t be too difficult to learn the basics.
Cheers and take care,
May 4, 2011
As a value investor I try to read as much as I can on the subject. I straight-forward and practical introduction to this type of investing is given in Roger Montgomery’s Value.Able. The key message he tries to impart is the importance of Return on Equity, over other more common performance measurements.
Equity is what’s put in (by the shareholders) and left in (through retained earnings). A return on equity calculation can be made at www.ratioanalysis.net, but its importance is based on the fact that it measures the success of management in using shareholder funds. And this is what we are, shareholders, and why we should care.
Take two companies: Alpha and Beta.
Both generate earnings of $10 million and have no preference dividends.
Which one would you invest in?…Hard to pick isn’t it; although most of the financial press will only highlight these earnings or other EPS figures.
Now, what if I said that Alpha had shareholder funds (equity) of $500 million, and Beta had shareholder funds of $50 million.
Beta can generate the same profit while only requiring and risking one-tenth of your hard-earned capital.
Now which one would you invest in?…Much easier isn’t it.
The ability of a business to generate a profit from a set amount of equity can be measured by Return on Equity (ROE).
In this example. Alpha’s ROE 2% while Beta’s is a healthy 20%
While profits can be fuzzy after mergers and acquisitions, or assets swollen by extra debt, the ROE is always a good measure of what everyday shareholders should care about. The return on their funds in the business.
Cheers and take care,
April 30, 2011
It is a common mistake to believe that the calculation of financial ratios is a black and white process. There is a belief that there is only one ‘right’ formula.
In fact, which formula you end up calculating depends on the source of your information as different texts and/or different teachers can use different methods. And, in fact, they are ALL generally the ‘right’ formula.
Unless you are getting advice from a quack, the formula you use will most likely be based on tried and tested research, but there are still subtle differences depending on your source.
A very common difference is when a ratio formula uses an average, instead of a single figure. For example, within a return on assets calculation, some formulas use a single asset figure, such as that stated in the most recent balance sheet. In contrast, some formulas use an average of the most recent asset figure (the end of the period) summed with the previous asset figure (the beginning of the period) divided by two.
While I choose to use the average figure in my calculations because I believe you are using the assets throughout the entire year to generate your return (as opposed to using the assets at the end of the period), there is no true right or wrong answer.
What is important is that you use the same calculation consistently and look for trends (as mentioned in the previous post). Also, if you have a choice of formulas, try to look behind the formula and see where the differences may lie and don’t cheat yourself by choosing the formula that may give you the result you want to hear.
The bottom line: be consistent and understand the subtle differences.