BT: Ratios to judge a firm's health

Business Times - 19 Nov 2007

Ratios to judge a firm's health

CHEN HUIFEN looks at key financial ratios that can help to evaluate the comparative performance of companies

IN OUR previous two instalments, we discussed the value of annual reports, and how investors can pick out useful information from both the prose and numbers.

We also looked at the fundamentals behind the three main financial statements - the profit and loss statement, the balance sheet and the cash flow.

Based on the information above, analysts can derive key financial ratios that help them in their assessment of a company's past and current health. To draw a simple analogy, some consumers base their car buying decisions on the fuel mileage they can get. Similarly, financial ratios are tools to judge the comparative performance of companies.

There are probably some 20 major financial ratios that analysts can churn out when they evaluate the operating performance and capital structure of companies. Here, we pick out some of the key ones.

Net profit margin

Net profit margin measures the amount of money a company makes for every dollar of sales generated. So, the higher the number, the better. It is typically presented in percentage terms. For example, Singapore Press Holdings (SPH) recently reported a full year net profit of $506.2 million, on a revenue of $1.16 billion. Its net profit margin is therefore

Net profit/revenue = $506.2 million/$1,160 million
= 43.6 per cent.

Return on equity

Commonly referred to as ROE, return on equity indicates how effectively a company generates profits out of its shareholders' funds compared to its peers in the same industry. There is more than one way of calculating ROE. The simplest is

ROE = Net profit/Shareholders' equity

So if a company makes $506.2 million and has shareholders' equity of about $2.2 billion, then its
ROE = $506.2 million/$2,200 million
= 23 per cent

Earnings per share

One of the key indicators of profitability, earnings per share or EPS is derived by dividing the net profit by the number of shares issued. So if a company makes $506.2 million and has 1.58 billion shares, then its

EPS = net profit/total weighted average number of shares
= $506.2 million/1,580 million shares
= $0.32 (or 32 cents)

Price to earnings ratio

With the EPS derived above, you can generate the price to earnings (PE) ratio. Analysts usually compare the PE ratios of companies in the same industry to judge if they are expensive or cheap when benchmarked against their peers. Note that the PE is influenced by a number of factors, including the price volatility of the company's share on the stock market and its earnings growth. Typically, the higher the PE, the greater the expectations of a company's future outlook.
Hence, if a company is trading at $4.50 and has an EPS of $0.32, then its

PE = Share price/EPS
= 4.50/0.32
= 14

Price to book value

Like the PE ratio, the price to book value (or PTB) is often used to compute stock values. The 'price' in PTB refers to the common stock price, while the 'book' is the book value of equity - the difference between a company's assets and its liabilities. In other words,
PTB = Market capitalisation/Total book value of its equity

One of the disadvantages of using PTB is that it is subject to accounting decisions on depreciation and other variables. On the other hand, it provides an alternative ratio to look at if a company is in the red, and therefore has no PE ratio to speak of.

Dividend yield

Dividend yield is the amount of dividend a shareholder can collect for every share that he owns.
Hence,

Dividend yield = Annual dividends received per share/Share price of the stock

As an example, SPH will be paying out 26 cents per share this year, so its dividend yield is therefore

26 cents/448 cents (price of stock as of Friday) = 5.8%

Gearing

Also known as financial leverage, gearing gives an idea of how a company funds its business - what proportion of its operations is being financed through debt, against shareholders' funds?
Gearing = Long-term liabilities/Shareholders' funds

Bear in mind that financial ratios should be evaluated together with knowledge of the company's operations, strategies and trends in the industry. None of them is meaningful on its own and should not be taken as the ultimate guide to a company's value. They should be looked at in conjunction with developments of the company, the performance of its peers, and not least, macroeconomic trends.