Understand the Key Measures for Your Investment Portfolio
In order to describe the old-school investment approach used in the UK, investors use important company financial attributes. These measures take a specific security and then attempt to look at the fundamentals that lie behind the share price or at the share price itself. Here’s a brief introduction to the key measuring tools that help you build your portfolio with more confidence:
Profits (or earnings): Probably the most widely used set of numbers by all forms of equity investors. A business’s profits are the result of subtracting the net costs from the total cash sales, and from this figure deducting dividends paid out, capital expenditure and taxes.
Many company managements manipulate their earnings, regularly exempting supposedly one-off costs from the final profit figure.
Price to earnings (PE) ratio: A way of relating the flow of earnings to the market capitalisation (the total dollar value of the company’s outstanding shares) of the firm. If a company is valued at £100 million and produces net profits before tax of £10 million, its share price to earnings ratio is ten.
The PE ratio is also sometimes used in an inverse sense via the earnings yield. In this example, the earnings yield of the £10 million profit-making company is 10 per cent; that is, 10 per cent of the market value is accounted for by its earnings.
Cash flow: Many investors focus closely on the cash flow coming into the business because earnings are by their nature a tad suspicious. (Corporate managers and their accountants can deploy hundreds of different ruses to ‘reshape’ profits.)
The purest concept is free cash flow, which contains all the net cash profits coming into the business after dividends, capital expenditure and any other exceptional expenses – the company is making large investments (hopefully in things that will yield a high return!), for example – are excluded.
Dividend yield: Much beloved by cynical investors. Theoretically you can only pay out hard cash dividends if you have enough hard cash profits, and so dividends are the last bit of the cash pipeline that can be handed back to investors as their annual reward. The yield is the dividend payout as a ratio against the market value of the company.
Book value: The residual value after everything has been accounted for that belongs to the investors. This measurement forces investors to look at the total assets of the business less all liabilities, which they hope is positive! Curiously, the book value of the business is virtually never the same as the market value of the shares combined.
Debt: Closely watched by many investors and simply measured as all the short- and long-term debt facilities versus either the book value of the business or the market value of the business.
Share price: Indicated by the market makers. The share price has its own momentum, or lack of it! Many investors like to see a share price that’s moving ahead steadily over time relative to the market. In contrast most investors view with suspicion a share price that goes nowhere for long periods or starts steadily falling, although contrarians are attracted to these poor momentum stocks.