Smart Investor: Getting Started, April 2013

Smart Investor, April 2013

Getting Started

The financial pages can be intimidating, and none more so than the lines of data that appear in publications like the Australian Financial Review at the back of the markets section. But the good news is that these numbers are much easier to decode than you’d think. Learning about just two of the ratios that typically appear in financial pages will give you a useful tool to evaluate shares to buy or sell.

In this article we’ll explain two magic numbers: return on equity and the price/earnings ratio. They don’t tell you everything; no number does. But they’re a handy metric to understand.

Let’s start with the price/earnings, or PE ratio, as it is commonly known. It’s very simple to work out: the market price of a share, divided by the earnings per share. If a stock is trading at $10 per share, and reports an annual profit of $1 per share, its price/earnings ratio is 10. To put it another way, if you buy it today, you are paying 10 times annual earnings.

The truth is, you generally don’t have to crunch the numbers yourself; financial publications often print the historical (or trailing) P/E of big stocks for your perusal.

So what’s a good P/E? Well, in isolation, it’s not really much use. Instead, P/Es are chiefly useful to compare one thing to another. If one company has a P/E of 15 and the other 20, then the first one is cheaper in terms of what you’re paying relative to what it earns.

However, it’s not as simple as just going for the cheapest one. Firstly, it’s only really useful to compare P/Es of companies in the same sector, because some sectors always trade at higher multiples than others. Tech stocks, for example, tend to trade at high P/Es, industrials at lower ones.

Secondly, just because something’s cheap, doesn’t mean it’s good. You always have to step back and have a think. Does this company have a particular product that justifies a high P/E, and if so, do you think it’s going to continue to generate great earnings? If so, maybe the high P/E stock is the better buy.

Still, many contrarian investors do look for falling P/Es as a good time to consider going into a stock, whether because it indicates a low point in a cycle and a good buying opportunity, or some other form of macro stress that will eventually correct itself.

On to return on equity, or ROE. First, here’s the sum involved: net income, divided by shareholders’ equity. To get the net income bit, you want to find the profit after tax. And to get the shareholders’ equity part, that means the stake in the company currently held by equity investors.

Mercifully, once again, you’re not going to have to spend too long with a calculator trying to crunch these numbers for your portfolio, because the financial press makes the ROE number freely available. It’s more important to understand what this calculation represents: the amount of profit made with the money that shareholders like you have put in to the stock.

Once again, this number is useless in isolation, very handy in comparison. You can compare the profitability of, say, Woolworths, with that of Coles; or NAB with Westpac. It gives you a relative sense of how well management is using your money to get the job done. It is often said that Warren Buffett, arguably the world’s most famous and successful investor, swears by ROE.

But here’s the thing: you can bet that Buffett doesn’t only  swear by ROE. Like all the best investors, he uses it as one tool in the toolkit, among many, and realises that ROE cannot tell you everything. Like the PE, it is not comparable between industries; ROE is usually higher for a company with high intellectual property and low incremental costs, than an industrial that has high costs to create products with long lifespans. Some investors say that ROE is a useful way of screening technology and consumer discretionary stocks, but not financials and utilities. Again, a decision to buy a share has to be taken on more than numbers: do you know and trust the brand, and like their products? What’s their competitive environment like? Is this a part of the economic cycle that suits it? Is the management stable?

Both these ratios, and others like price to book, are useful ways of slimming down a number of stocks you might be considering investing in. They are worth keeping an eye on once you own a stock too, as they might be a helpful guide in working out when to sell. And put it this way: you’re better informed knowing what they mean, than not knowing and just turning the financial pages.

BOX: EXAMPLE

On February 15, according to data from Capital IQ (which is what feeds Yahoo Finance, among others), Westpac had a return on equity of 13.41%, and a forward P/E of 13.07. Commonwealth Bank of Australia had a return on equity of 18.02%, and a forward P/E of 14.14.

First of all, what’s a forward P/E? The main article talked about trailing P/Es. A trailing ratio is based on historical numbers, already reported; a forward P/E is based on analyst expectations of what a stock is going to deliver in the coming financial year.

The ROE numbers tell us that CBA is delivering more bang for its buck than Westpac is: 18% versus 13.4%. CBA appears to be doing a better job of turning shareholder equity into profit. The P/E numbers tell us that, indeed, the market agrees, because you have to pay more to get a slice of CBA’s performance than you do for Westpac’s: just over 14 times earnings for CBA compared to 13 for Westpac’s. Right here, we see how two ratios act as a check and balance on one another, confirming that the better performance we see in the ROE number is being noticed by the market in the P/E number.

But ANZ had a ROE of 14.32%, and a forward P/E of 11.72. In other words, more efficient performance than Westpac, but with a lower P/E. On first glance, that appears to suggest that ANZ is a better value investment than Westpac.

Is it? Well, you’d then have to make other inquiries: which bank do you like? What’s doing best in wealth management? How important is presence in Asia? There are lots of other questions to ask. But our two ratios have allowed you to ask them from a position of strength.