Interactive Investor

Summary of analysis used to value and assess prospects of an investment

Price/Earnings ratio (P/E)

The price/earnings (P/E) ratio is the most common way of valuing a stock, and a key ratio for analysts and investors alike. Calculate it by dividing a company’s share price by earnings per share (EPS). We typically use forecast EPS in our calculations.

Typically, the higher the predicted growth in profits, the higher the P/E. Dull, non-growth stocks tend to have lower P/E's, and often higher yields. The ‘earnings’ part of the calculation can make things more complicated, however. Forecasting is an inexact science and analyst forecasts can change quickly, although forecasts should improve the nearer a company gets to financial year end.

Crucially, P/E does enable companies to be compared irrespective of their size. Stockmarket index compilers calculate the PE of the index as a whole and of sector groups, so that investors can see how the company's valuation compares with the market as a whole.

But, the higher P/E on growth stocks can be a double-edged sword. If forecast profits turn out to be less than expected, growth is, too, so the basis for the high PE collapses along with the share price.

Net Asset Value (NAV)

Net asset value (NAV) is a term used when valuing investment trusts, including property companies and others whose balance sheets are full of valuable assets or investments.

Take the difference between total assets and total liabilities - a figure termed shareholders' equity – and divide by the number of issued shares to get at a per share value. This is then compared with the share price.

Often, the shares of asset-rich companies sell at a discount to their true underlying value, as expressed by NAV. In theory, the bigger the discount, the greater the undervaluation, although the absolute level of any discount to NAV doesn't tell you enough.

Lots of things affect the level of discount or premium, among them sentiment around the investment company's assets, its strategy and whichever assets it owns. Popular trusts typically trade at a narrower discount or premium to NAV.

Price/Book ratio (P/B)

The price/book (P/B), price/tangible book, price/net current assets, price/cash (P/C) ratios and so on, compare a company’s share price against what it owns and can be a more reliable proxy for value than other ratios.

P/B is calculated by dividing a company’s share price by its book value (net assets minus intangible assets) per share. Low ratios suggest the stock might be undervalued, but there could also be a problem, and sometimes the carrying value of an asset on the balance sheet may not always reflect its true value, either higher or lower.

Values do vary between industries, and P/B is simply no use when trying to value companies in sectors like technology or pharmaceuticals where much of the value of the business is intangible, reflected more in intellectual property, goodwill and brand awareness. Far better to use this ratio when valuing financial institutions or manufacturers.

Free Cash Flow (FCF)

Anyone who’s run a business will tell you, cash flow is different to profits. Profits are stated after notional debits and credits that don't involve actual movements of cash. Cash flow ignores these book entries and concentrates on the flows of cash into and out of a business.

Operating cash flow ignores depreciation, amortisation of goodwill, retained profits of minority owned companies, capitalised interest and other concepts the result of accounting conventions. Free cash flow also subtracts items that a company cannot avoid paying: interest, tax, and sufficient capital spending to maintain its fixed assets.

Free cash flow represents the amount of cash left over after all essential deductions have been made. That can go towards dividends, acquisitions, share buy-backs, "organic" capital investment in the business, or it can simply be retained.

It is one of the acid tests of a company's ability to survive difficult times and a good yardstick for assessing the true value of a company's shares. FCF is a starting point for many valuation ratios, including discounted cash flow, price to cash flow (or its inverse, the free cash flow yield). Some investors also look at free cash flow as a percentage of sales.

There are no hard and fast rules for interpreting numbers like this, but market capitalisation/FCF of less than 10 times and, conversely, a FCF yield (free cash flow as a percentage of market capitalisation) over 10% is considered to be high.

Enterprise Value/EBITDA

EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation. It is in effect, operating profit after adding back specific non-cash items of depreciation and amortisation, and is usually much larger than pre-tax profit because interest charges are ignored.

It is generally used in the context of company valuation as a ratio to enterprise value (EV), a company's net debt plus its equity market capitalisation.

EV/EBITDA values a company irrespective of its capital structure. It is a valid way of comparing companies with high levels of debt or lots of cash, or those that are making losses at the net income level but not necessarily further up the profit and loss column. Because we're using a figure taken before deducting tax, you can also use it for comparing companies internationally.

Price/Sales ratio (PSR)

One of the simplest ratios for valuing companies is the price/sales ratio (PSR), which relates the market value of the company to annual sales. It’s a ratio closely associated with John O'Shaughnessy in his book What Works on Wall Street.

He found that PSR was one of the best indicators of future share price performance. Companies with a PSR of less than one (that is, with a market capitalisation less than their annual sales) generally performed well, while those greater than one underperformed.

There are conceptual difficulties over the PSR. All companies are different from each other and have different levels of profitability. Revenue for food retail companies is often many times their market value because their profit margins are typically very low.

The PSR is a hard concept to use for any company that uses a convention for calculating revenue that differs from the normal mainstream. As well as financial companies, the PSR also has limited relevance for companies described as 'asset situations'. Here, value rests on relating the value of assets to the (usually substantially lower) market value of the company.

Taking the PSR in isolation risks oversimplifying matters. But the ratio can be used as one of a range of measures to value companies, along with return on equity, the P/E ratio, price/cash flow ratios, discounted cash flow and other calculations.

Dividend Yield

Picking quality high-yield stocks is something of a Holy Grail of investing. It works because if most of the expected long-term average annual return from equities can be captured in the form of dividend yield, the market can typically supply the little that is needed on top. In simple terms, it does a lot of the hard work for you in terms of achieving high returns.

The high return generated consistently by most high-yield stocks does not come without risks, the biggest being a dividend cut. But the compound effect of a high yield over time, if reinvested, is powerful.

Super-high yields are typically treated with wariness. Look for those with stable businesses rather than cyclical ones, and for dividend cover of at least two times earnings, although this can be relaxed for more stable companies. A stated dividend policy of regular increases above inflation reinforces the reliability of a company's yield. Low debt, or large cash balances limit the chance of a dividend cut.

Technical Analysis

While a balance sheet can tell you a lot about the financial health of a company, technical analysis can help investors more precisely time the purchase of a share they may have already decided looks attractive on fundamental grounds.

Interpretation of charts reflects investor psychology. Zones of support and resistance exist because of our reluctance, for example, to sell until a losing share returns to the price we paid for it, or to pay more for a share that has shot up until it comes down to a more 'reasonable' level.

Some traders do invest using only chart patterns, and technical analysis does assist in spotting the points at which profitable trades can be made, but we prefer to combine the use of indicators like support, resistance and Fibonacci levels, with fundamental analysis.