Metrics for sound investment decision

Investment in the stock market requires deliberate effort to ensure more wins and fewer losses. At that, investors need to constantly gauge the performance of the companies in their investment portfolios.

A typical company is under the obligation to release its result to the market at least four times a year; that is first quarter, second quarter, third quarter and the audited full year result.

To make sound investment decisions, there are metrics that can be calculated out of the figures released by these companies.

These metrics include: turnover growth, profit after tax growth, earnings per share, profit margin, P/E ratio, earnings yield, dividend yield, book value, Free Cash Flow, Return on Assets and Return on Equity.

TURNOVER GROWTH

Turnover is the money generated from normal business operations. It is the top line figure from which costs are subtracted to determine net income. It is also called Revenue, Gross Earnings or Gross Income.

Turnover growth illustrates sales increases/decreases over time. It is used to measure how fast a business is expanding. Revenue growth helps investors identify trends in order to gauge revenue growth over time.

To calculate turnover growth as a percentage, you subtract the previous period’s revenue from the current period’s revenue, and then divide that number by the previous period’s revenue. So, if you earned N1 million in revenue last year and N2 million this year, then your growth is 100 percent.

(Current Period Revenue – Prior Period revenue) / Prior period revenue. It is expressed in percentage.

PROFIT AFTER TAX GROWTH

Profit after tax (PAT) can be termed as the net profit available for the shareholders after paying all the expenses and taxes by the business unit.

Tax is an integral part of an ongoing business. After paying all the operating expenses, non-operating expenses, interest on a loan, etc., the business is left out with several profits, which is known as profit before tax or PBT. After that, the tax is calculated on the available profit. After deducting the taxation amount, the business derives its net profit or profit after tax (PAT).

To calculate growth in profit after tax, same formula applies as that for turnover growth.

EARNINGS PER SHARE

Earnings per share (EPS) is calculated as a company’s profit after tax divided by the outstanding number of shares. The resulting number serves as an indicator of a company’s profitability.

The higher a company’s EPS, the more profitable it is considered to be.

EPS indicates how much money a company makes for each share of its stock and is a widely used metric for estimating corporate value.

A higher EPS indicates greater value because investors will pay more for a company’s shares if they think the company has higher profits relative to its share price.

PROFIT MARGIN

Profit margin is used to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits. Simply put, the percentage figure indicates how much of profit the business has generated for each Naira of sale.

It is calculated as Profit after tax divided by Turnover, multiplied by 100.

P/E RATIO

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company. It measures its current share price relative to its earnings per share (EPS). 

It is simply current share price divided by earnings per share.

P/E ratios are used by investors and analysts to determine the relative value of a company’s shares. It can be used to compare a company against its own historical record.

A high P/E ratio could mean that a company’s stock is overvalued, or else that investors are expecting high growth rates in the future.

EARNINGS YIELD

The earnings yield refers to the earnings per share divided by the current market price, multiplied by 100. The earnings yield is the inverse of the P/E ratio. It shows the percentage of a company’s earnings per share.

DIVIDEND YIELD

The dividend yield is a financial ratio that shows how much a company pays out in dividends relative to its stock price. It is calculated as dividend/price, multiplied by 100.

BOOK VALUE

The Book Value of a company is the net difference between that company’s total assets and total liabilities, where book value reflects the total value of a company’s assets that shareholders of that company would receive if the company were to be liquidated.

Book value per share (BVPS) is a method to calculate the per-share book value of a company based on common shareholders’ equity in the company. Should the company dissolve, the book value per common share indicates the Naira value remaining for ordinary shareholders after all assets are liquidated and all debtors are paid. 

If a company’s BVPS is higher than its market value per share, then its stock may be considered to be undervalued.

Book value per share (BVPS) is calculated by dividing shareholders’ equity by outstanding number of shares.

FREE CASH FLOW (FCF)

Free cash flow (FCF) represents the cash available for the company to repay creditors or pay dividends and interest to investors.

FCF reconciles net income by adjusting for non-cash expenses, changes in working capital, and capital expenditures (CAPEX).

FCF can reveal problems in the fundamentals before they arise on the income statement.

There are three approaches that can be used in calculating Free Cash Flow (FCF). This include:

  • Net Income approach
  • EBIT (Earnings Before Interest and Taxes) approach
  • CFO (Cash Flow from Operations) approach

Net Income Approach

FCF = Profit after tax + Depreciation/Amortisation + Interest expense (net of tax) +/- working capital changes – Capital expenditure


EBIT Approach

FCF= EBIT – Taxation + Depreciation/Amortisation +/- working capital changes – Capital expenditure

CFO Approach

FCF = Cash flow from Operating activities + Interest expense (net of tax) – capital expenditure

While FCF is a useful tool, it is not subject to the same financial disclosure requirements as other line items in the financial statements. FCF is a good double-check on a company’s reported profitability. Although the effort is worth it, not all investors have the background knowledge or are willing to dedicate the time to calculate the number manually.

Using the trend of FCF can help you simplify your analysis.

If stock prices are a function of the underlying fundamentals, then a positive FCF trend should be correlated with positive stock price trends on average.

A common approach is to use the stability of FCF trends as a measure of risk. If the trend of FCF is stable over the last four to five years, then bullish trends in the stock are less likely to be disrupted in the future. However, falling FCF trends, especially FCF trends that are very different compared to earnings and sales trends, indicate a higher likelihood of negative price performance in the future.

RETURN ON ASSETS

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company’s management is at using its assets to generate earnings.

ROA is profit after tax divided by total assets, multiplied by 100. The higher the ROA is, the better.

RETURN ON EQUITY

Return on equity (ROE) is a measure of financial performance calculated by dividing profit after tax by shareholders’ equity. ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits.

Source: Metrics for sound investment decision – StocksWatch (stocksng.com)

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