Share Ratios are useful in helping to chose what shares to buy, the P/E Ratio, Dividend Yield and Gearing Ratios are helpful in giving a view as to the value, income prospects and riskiness of a share.
What is a Share Ratio?
A Share Ratio or Financial Ratio simply shows the value of one item in relation to another. When it comes to shares this concept is particularly useful for you in determining whether a share is actually good value.
A share price itself means little itself – it may have gone up or down, but share ratios can give you food for thought as to the prospects of a share going forward.
The majority of these are found online or on share charts such as Google Finance – so there’s no need to calculate them yourself.
So let’s take a look at a few of the key ones.
Is the Company Under/Over-Valued? Enter P/E and PEG
These ratios are designed to help you quickly evaluate whether a company is valued too high or low.
The Price/Earnings Ratio (or P/E Ratio) highlights the price that you are paying per each pound of the earnings of a company. A lower ratio is often seen as better in this context because it means that you are paying less for the earnings, suggesting the company is undervalued. However, comparisons should only be done on a like-for-like basis on companies in the same industry.
The P/E Ratio has a severe limitation in that it only looks at historical performance. Step in the Price/Earnings Growth Ratio or PEG. The PEG ratio also adds growth prospects into the equation.
A PEG Ratio of 1 indicates a solid match between the value of a company and it’s expected earnings growth. Lower than 1 suggests the company is undervalued (because you are paying less for expected earnings in future), above 1 suggests it is overvalued.
To calculate PEG (P/E Ratio / Expected Growth), you first need to calculate the P/E Ratio (Share Price / Earnings Per Share). However, these do not tell the whole story, for example a PEG Ratio is only as reliable as the growth forecast that underpins it. Likewise, a P/E Ratio can be affected by different account practices and the way earnings are reported between different companies.
Will the Share Provide a Good Income?
When investing in shares, you may not look for outright capital growth (or increase in the share price), but also the ability to provide a good bank-busting rate of income.
Enter the Dividend Yield. A simple formula that equates to the Dividend Per Share / Share Price. A dividend yield will be expressed in % terms, making comparisons easy. A high dividend provides a good income but may also raise questions as to why? Is the company feeling less positive on its growth prospects? Hence the increase dividend yield protects investors from a falling share price.
Similarly a low yield could be taken as a positive sign in that the company has a exciting growth prospects or that it’s poor performance means it just can’t afford to pay dividends to investors.
A key ‘partner’ ratio is the Dividend Cover ratio (Earnings Per Share / Dividend Per Share) – it highlights the number of times that the profit of a company can pay for the dividend. The higher it is (2+), the better, this is because it means there is likely more certainty of the dividend.
A ratio of less than 1.5 falls into risky territory and anything below 1 raises serious concerns as the company is paying
Is the Company Swimming in Debt? Gearing Ratios
High levels of debt are a warning sign for any company. Therefore Gearing Ratios are useful ones to take note of as it reflects the leverage or funds borrowed by a company (rather than financed by equity).
A simple way to calculate this is to add the borrowings of a company (long / short term debt and overdrafts) and / shareholder equity.
High gearing ratios of 50%+ raise alarm bells, however anything between 25% and 50% is considered optimal. Anything lower than 25% is seen as low.
Good Place to Start but There’s More Homework to Do
Various Share Ratios are good places to start when evaluating the prospects of shares. But there are pros and cons of each. For example, a high gearing may be due to a risky strategy, but if it pays off, the share price will surge. Moreover, a low P/E ratio may mean there is some very justified rationale behind the apparent undervaluation of a company.
They should be used to help make an informed decision, but not the only basis of a decision.