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Company accounts analysis
Successful ratio analysis
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Use ratios to evaluate quoted companies against both their own past years, and competitors in the same sector. |
The main ratios that you need to understand as an investor are:
- Profit related ratios
- Liquidity ratios
- Dividend ratios
- Other ratios
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Where do you find the figures that make up the ratios? From the
company report and accounts.
Although you can usually find ratios ready calculated, understand how they are
made up and they will mean more to you.
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Click the button below to access an
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Below, we look at key ratios in detail:
(1) Profit-related ratios
The PE ratio
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The
PE ratio is a yardstick for assessing how a company is rated against
its peers. It consists of the share price, divided by the earnings per
share (eps). The eps is defined as profits after tax divided by the number
of shares in issue.
If a company's PE is high compared with the sector and/or
market average, the shares could be overvalued. If the PE is low,
the shares could be undervalued.
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Warning
In comparing PE ratios, make sure that you are setting like against like. A company's historic PE (using last year's
eps) should be compared with the same for a similar company, or the sector as a whole. Similarly for the prospective PE. |
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The PEG ratio
The PEG shows the
PE ratio in relation to the company's earnings growth rate. It is the prospective
PE ratio divided by the prospective average eps growth. If the result is
significantly less than one, it could represent value.
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Limitations of PEG
Use this ratio to evaluate growth stocks. It does not work so well for cyclical or recovery stocks.
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Return on capital employed
The ROCE is a useful yardstick for assessing management performance. In its simplest form, it is calculated as profits before interest
payable and tax, divided by capital employed.
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Look for a rising ROCE
The higher a company's return on capital employed, the better the company is using the assets at its disposal. Ideally, the ROCE should be rising year on year. |
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(2) Liquidity ratios
EV/EBITDA - a cash flow-related measure
In assessing capital-intensive stocks such as in the telecoms sector, the EV/EBITDA ratio is useful. This is the enterprise value (market capitalisation + debt less cash) divided by EBITDA (earnings before interest, tax, depreciation and amortisation).
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The EBITDA flatters companies that write off substantial amortisation every year after acquiring purchased goodwill.
This is because EBITDA, estimated for future years on the basis of discounted cash flows, ignores the impact of amortisation. The earnings per share (less flatteringly) takes it into account.
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Share price/cash flow per share
The share price/cash flow per share is the stock's market value, divided by total cash flow (profits plus depreciation and amortisation).
A price/cash flow per share ratio which is lower than eps/share is a strong indicator of value. This is something you should look for.
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Professional analysts forecast future cash flows, and then discount them back to a present day value. To find out how this is done, click here. |
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Current and quick ratios
A vital check on a company's liquidity is the current ratio. This is current assets divided by current liabilities (figures available on the balance sheet).
To be comfortable, the current ratio should be over 2, but some sectors do not need so high a figure.
The quick ratio (acid test) is current assets less stock and work-in-progress
divided by current liabilities (all figures again on the balance sheet). It
should be over 1.
(3) Dividend ratios
Dividend yield
The dividend yield is the gross annual dividend expressed as a percentage of the share price. Again, it is best measured against that of the company's peers.
As a company's share price falls, its yield rises. A high yield is seen as advantageous for value investors as it suggests an out-of-favour company – which may, however, be facing business problems.
Dividend cover
Dividend cover assesses a company's financial soundness. It is earnings per share, divided by dividend per share.
If dividend cover should fall below 1, the company faces problems. It will be unable to pay its dividend out of current earnings.
(4) Other ratios
Price/sales ratio
The price/sales ratio
(PSR) is the total market value of the company divided by the previous year's
sales. A PSR of less than 1.5 can be a strong indicator of
value. In the past, analysts have used the PSR to evaluate non-profit making
Internet companies.
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In the past, analysts have used the PSR to evaluate non-profit making Internet companies. In current markets, they are looking for profits in this sector, and the PSR is less popular. |
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Share price/net asset value per share
The share price/net asset value (NAV) per share is the total assets less total liabilities, divided by the number of shares in issue. This is useful for valuing property companies, investment trusts, and composite insurers.
Gearing
This is a company's
level of borrowing. The gearing ratio is interest-bearing loans and preference
share capital, divided by ordinary shareholders' funds, all expressed as a percentage.
If the figure is much over 50%, it is your cue to start asking questions.
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Assess a company by a number of yardsticks
A stock may appear good value on one ratio, but poor on another. So
use a number of ratios in analysing a stock and look for agreement in the story
they tell.
Your chosen investment should ideally have a low PE ratio, a low PSR, a low price/cash flow and a high and rising ROCE. It should also have strong discounted cash flow projections from a number of analysts. |
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To get further to grips with ratio analysis, read How to Win in a Volatile Stock Market by Alexander Davidson.
Ratio analysis is covered more briskly in Everyone's
Guide to Online Stock Market Investing by Alexander Davidson.
Find ratio analysis boring? Stock Market Rollercoaster sweetens the pill by presenting it in fictional form.
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