1) Operating Margin (OP/Sales): Efficiency of the firm’s operations, this no. range from -90% to +90%, the higher the better.
2) Asset Turnover (Sales/Total Asset): Efficiency of the firm’s assets in creating sales, this no. is usually 1.x, the higher the better.
3) Return on Equity (Net Profit/Equity): Rate of return attributed to shareholders, this no. is usually 5-40%, on average around 20%, the higher the better.
4) Return on Asset (Net Profit/Total Asset): Rate of return attributed to the whole firm, this no. is usually 2-30%, the higher the better.
5) Dividend Yield (Dividend per share/Share Price): Rate of return of dividends, this no. is usually 0% to 10%. In Singapore, anything higher than 5% is considered very good.
6) Other ratios that we talked about: PER, PBR, Net debt-to-equity, cash-to-market cap, EV/EBITDA.
7) Another 10,016 ratios that we did not talk about, created by Wall Street analysts. Maybe you can still find 1 or 2 useful ratios in there.
Price Earnings Ratio
The P/E ratio is the most widely used yardstick to value a stock (i.e. to see if the stock is cheap or expensive). It is simply the price of the stock divided by its earnings per share. E.g. SMRT trades at $1.40 today, and its expected EPS for 2007 is $0.08, if you divide $1.40 by $0.08, you get SMRT’s P/E ratio which is 18x.
PER tries to determine the value of a product by dividing its price by its quality. Here the quality of the company is determined by how much money it makes.
Forward PER
PER may be a simple concept but its application can actually be quite complicated. PER Price Earnings Ratio of a stock, determine the cheapness of the stock by dividing the stock price by its earnings per share (or EPS).
Which EPS should we use to calculate PER? Is it the latest historical EPS announced by the co.? Or what?
The answer is the expected EPS in 1 yr’s time (not announced by the co. yet, i.e. it is not in the annual report). The resultant PER is also called the forward PER. The reason is very simple. The stock market always look forward, not backward. It is the cumulation of the expectations of all the players in the market. Hence when using the expected EPS of the stock in 1 yr’s time to calculated PER, we roughly get a good sense of the market’s expectation of the value of the stock.
BTW, this expected EPS (also called the consensus EPS) is usually the average of all the sell-side analysts EPS estimates for the next year and this no. can be easily pulled off bloomberg or other financial information providers.
As a rough gauge, I would consider anything less than PER 18x as cheap and I would not buy any stocks that is trading at more than PER 18x.
EPS
Basically you must first have an idea of what is the true PER of the stock, and what is its potential EPS, say 5 yrs down the road. Then you can multiply PER by EPS and get the intrinsic value or target price. (Yes this is the dreaded target price given by analysts, and yes, none of them ever got that right and most likely, yours truly here won’t get it as well.)
PER = Share price / Earnings per share (EPS)
Intrinsic value or target share price = true PER x potential EPS
So, how do we know what is the true PER of the stock? Usually by looking at the market and industry PER. So today, STI trades at 15x PER and the airlines in Asia trade at 20x on average. So we can assume that SIA should trade roughly around this range. Let’s arbitrarily assume that the true PER for SIA is 17x.
Next we need to determine its potential EPS. SIA managed an EPS of $1 in 2005. So assuming that it can maintain this level, say 5 yrs later. We have its potential EPS at $1. So to get its intrinsic value (or target price), simply multiply 17 x 1 = $17. SIA should trade at $17. Today it is trading at $15.7.
Market cap (or market capitalization)
Market capitalization (a.k.a. market cap) is simply the share price x the no. of outstanding shares that the company has issued.
It is a measure of the “perceived” value of the company. To paraphrase, market cap is what the participants in the stock market thinks how much a company is worth, it may or may not reflect its true value, or the intrinsic value of the firm.
Price to book
PBR = price of the stock divided by its book value per share.
The book value of a stock is also called its shareholders’ equity which is whatever that is left for shareholders after all its assets are sold and all its liabilities are paid off (shareholders’ equity = assets – liabilities)
By right, a stock should never trade below its book value, because this means that we should sell everything the co. has, pay all its debt and distribute what is left back to shareholders, which is more than the stock price on the market.
EV/EBITDA
EV/EBITDA measure the cheapness of a stock. i.e. similar to other valuation metrics like PER or PBR. EV stands for Enterprise Value which is the value of the entire firm to both shareholders and debtholders. Its formula is shown below:
EV = Market Cap + Net Debt
Market Cap = Read this post
Net Debt = Total Debt – Cash
And EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization.
So, in essence, EV/EBITDA tries to measure the intrinsic value or cheapness of a company, just like PER or PBR. But it looks at it from the perspective of both the shareholder and the debtor. (The other two ratios only look at it from the shareholder’s perspective.)
On top (the numerator), it takes into account both market value (or market cap) of the company, and its debt. At the bottom (the denominator), it looks at profits before interest, tax and even depreciation. Well from this ratio’s creator’s point of view, this is profit attributable to both the shareholder and the debtholder.
EV/EBITDA ranges from 5-25x nowadays with fair value usually at 10-15x.
Earnings yield
Earnings Yield is actually the return that you can get by investing in this stock. Say if a stock has an Earnings Yield of 10%, it means that by investing $100 in the stock, you would get $110 back by the end of the year.
Earnings yield is the reciprocal of the Price Earnings Ratio or P/E Ratio or PER.
P/E Ratio = Share price / Earnings per share (EPS)
Earnings yield = Earnings per share (EPS) / Share price
or
P/E Ratio = Mkt cap / Net Profit
Earnings yield = Net Profit / Market cap
Now if you get this, cheaper P/E means higher return right? Because Earnings Yield of 10% would mean that the P/E of the stock is 10x. (10% = 0.1 and reciprocal of 0.1 = 10.) And P/E of 10x is damn bloody cheap because it means that the stock can give you 10% return p.a. and as we all know (hopefully) investment on average earns you 5-8% over the long run.
Consider NOL, which trades at P/E of 3x, it means that its earnings yield is 33%. Sounds like a screaming buy right? Actually, it is a huge debate right now, nobody knows the answer. This is because no one is sure that the P/E can remain at 3x, say 5 yrs from now. This means that some players in the market think that NOL may lose truckloads of money in the next 5 yrs. And he is not willing to buy it now, even if NOL is super cheap today.
As with intrinsic value and forward PER (i.e. P/E ratio in the future) guesswork is involved here.
Dividend yield
Dividend yield is the stock dividend per share (DPS) divided by its share price. E.g. if Company A gives 10c dividend in 1 yr and its share price is $1, then its dividend yield is 10%.
Alas, as we all know, no stock will give a 10% dividend yield, even if it does, it cannot last because the company may not generate enough cash every year to pay this huge dividend.
In Singapore the average dividend yield is also around 3-4%, which is not much higher than fixed deposit rate, but actually quite ok by global standards.
Personally I think dividend is very important because it may be the only form of incremental income for a value investor (who prefers to buy and hold stocks). If a company does not pay dividend, there is no way to get cash out of your investment except by selling the shares.
Also, by paying dividend, the company shows that it has its shareholders in mind. Excess capital is always returned to shareholders if it cannot be put into better use.
Price Earnings Ratio and Earnings Yield
Earnings yield is the inverse of Price Earnings, meaning when I say I will only buy stocks with PER of 18x and below, I am actually saying I will only buy stocks with earnings yield of 5.6% and above. Or stocks that will give me 5.6% return over the long run. (1/18 is 0.056 or 5.6%, this is what I meant by the inverse)
For STI, the earnings yield currently is roughly 5% while the risk free rate is roughly 3%, so investors are being compensated an additional 2%, the equity risk premium, for investing in risky equities or stocks. That’s actually quite low by historical standards. Equity risk premium should be around 3-5% on average.
Return on Equity, Episode I (ROE-EP1): Beating the Cost of Equity
Return on Equity or ROE measure the return that can be earned by the portion of shareholders’ money in the company. Mathematically, it is defined as
Net Profit / Shareholders’ Equity
This is totally different from earnings yield so pls don’t get confused. ROE has to do with the financial performance of the company while earnings yield deals with the performance of the stock. Over the long run both should converge, but fundamentally they measure different things.
ROE measures the profitability of the company with respect to shareholders’ funding. Equity capital comes at a cost (just like debt) and a company with a low ROE runs the risk that it cannot earn its cost of capital (equity in this case) and this means that the company is in deep shit.
In other words, a company should earn its cost of equity in order to justify its existence to shareholders. The higher the ROE, the easier for the company to earn its cost of equity and the better the company is as an investment. This concept can be expanded to the cost of capital of the company, where we bring in the cost of debt together with the cost of equity. So a company has to earn a return more than its cost of capital to justify its existence to both shareholders and debtholders.
ROE can also be used to gauge a company’s organic growth rate. This means how fast the company can grow without relying on external factors.
So as you can see, ROE measures the growth rate of the company’s shareholders’ equity if the company does not distribute out net profits as dividends. (If it does, the growth rate simply becomes ROE x (1 – payout ratio), where payout ratio is between 0-100%.)
So when a company has an ROE of 20% and can maintain that, it means that the company can grow its equity base organically by 20% every year (i.e. without relying on M&A etc).
PS: Shareholders’ equity can grow by 20% per year doesn’t mean that stock price will also grow by 20% per year, There is difference between performance of the company and the performance of the stock!
ROE is impacted by these 3 things
1) Net margin (which is Net Profit / Sales)
2) Asset Turnover (which is Sales / Assets)
3) Leverage (which is Asset / Equity)
In order to increase the company’s ROE, we just need to improve either one of the 3 things mentioned above.
We can reduce cost, hence even if sales remains the same, net margin goes up, ROE goes up. We can increase asset turnover, i.e. by making our existing asset work harder to generate more sales. Or we can increase debt.
Now (1) and (3) are easy. For (1) you just fire a whole bunch of people, make the rest work harder, or hire 10,000 cheap workers from emerging countries to replace those you fired. For (3), it is even easier, just borrow more. By borrowing, you increase the liabilities that your co incurs thereby increasing your asset base (usually as an increase in cash) which can translate into more sales and profits if those cash or assets are used correctly and hence ROE goes up.
To improve ROE by improving (2) i.e. increasing Asset Turnover is one hell of a job. Basically, when you see a company with high ROE, it pays to see how this high ROE came about. If it is due to high debt, then maybe it’s a deception! So beware, there is more than meets the eye!
If it is due to either (1) or (2) then, probably it’s still ok. But if you see a company’s ROE improve over the years and it’s due to only (2), increase in Asset Turnover, then give the management some respect. It’s a job well done! And it is time to load the truck with stocks of this company!
Be $mart with Your Money 