There are nearly 80,000 mutual funds worldwide. Investors need a way to decide what investment is right for them. However, with so many metrics how do you decipher value? The answer isn’t buried in exhaustive investment guides. Instead, the winning strategy comes from a game show contestant in the 1980s.
Breaking the Board
In 1983 Michael Larson started recording episodes of a new game show called ‘Press Your Luck.’ Contestants hit their buzzer when they wanted to stop a chasing light circling a board. If they landed on the right square, they earned cash.
Larson noticed a flaw. The movement of the light across the board had only five patterns. He memorised all of them, flew to California and earned a spot on the show. His carefully timed gameplay landed him on the winning square every time. His ‘hack’ made him $110,237 in cash.
Investing is, of course, a more complicated game. However, the strange story of Larson offers a parallel to the stock market. Buried within the bells and whistles are a few key metrics. These numbers are the signals in the noise.
In this article, we’ll look at five key investing metrics. We’ll learn why they’re important and how to use them. Make smarter moves with just five numbers.
Successful investing comes from more than just share price growth. Dividends are another powerful driver of wealth. When a company hands over a portion of their earnings to an investor, they’re issuing a dividend (or a ‘yield’). These payments might be in the form of cash or stock. Companies pay dividends once or several times a year.
Why would an investor choose a company that doesn’t pay a dividend? Younger businesses rarely issue these payments because they need capital to expand. Investors of these companies are more interested in big growth than a dividend. Early-stage companies, however, often carry greater risk. A dividend is usually a sign of stability within a company. This balance is important especially in times of economic downturns. ‘Dividend-paying stocks have outperformed non-dividend-paying stocks for the five-year period following every recession since 1972,’ according to research.
Even in good times, dividend-paying stocks outperform non-payers. In the 30-year period ending December 31st, 2012 non-dividend S&P 500 stocks had average annual returns of just 1.6%. How did the dividend paying stock perform? They delivered 7.2%.
Take a moment to see if the fund or business offers a dividend.
The yield is expressed as a percentage. For example, a company might have a yield of 2%. This percentage means that if the share price is $80, then the annual dividend payment will be $1.60 (.02 x $80). Knowing this math, we can assume the higher the yield, the better the investment, right?
Failing companies may dramatically increase their yield. Why would they do this? They want to compensate for a falling share price. The reverse can also be true. Sometimes a high yield comes at a high share price. ‘Dividend-paying stocks currently are more expensive than they have been,’ recently warned The Wall Street Journal. Despite these unique cases, over the long-term, a dividend strategy works. Consider how dividend-payers can bolster performance in your portfolio.
Earnings Per Share
When you buy a share of a company, you become an owner. The earnings per share (EPS), in a sense, represent your paycheck. The EPS is the net income earned per share of stock. The calculation subtracts the dividends paid to preferred shareholders because this is money leaving the company. The equation looks like this:
EPS = Net Income – Preferred Dividends / Shares Outstanding
A rising EPS, expressed as a dollar figure, pushes share prices up. Over the last decade, this relationship has been clear. Prices in the S&P 500 have risen with EPS figures. The number represents more than profitability. A respectable EPS proves the value of the company to potential investors.
Wall Street analysts often measure how well a company hits an EPS forecast. A consistent or growing EPS is important because it represents the ability of a company to generate income. A solid EPS is a good indicator of financial health.
Is it a perfect measurement? No, because it can be misleading. Here’s why.
Companies can boost their EPS without increasing net income. How do they do this? They simply buy back shares. Doing so will reduce the denominator in the above calculation. As a result, the EPS figure climbs without any additional income flowing through the company. Additionally, a growing EPS can come at a high cost. A company may choose to generate more income by taking on more debt. In the short-term, this looks good to investors clamouring for a higher EPS. In the long run, however, the debt becomes burdensome to the longevity of the company.
As with any investment decision one should consider the long term. Stock prices can fluctuate significantly in one day due to a missed EPS forecast. This movement looks dramatic in the context of one day. However, it means little for the future. EPS trends create a more reliable picture.
Investing can be risky. EPS figures compensate you for this burden. Ask yourself if the pay is good enough.
It sounds intimidating but it shouldn’t. The P/E ratio comes from dividing the share price by the earnings per share (EPS). That’s it. If the share price is $50 and the EPS is $5, the P/E is 12.5 (50/5).
The P/E ratio is a tool for determining value. A P/E of 12.5 means investors are willing to pay $12.50 per $1 of earnings. Companies with high growth expectations often carry greater P/E ratios. That is, investors will pay more for each $1 of earnings because they believe share prices will rocket up. Here’s where the value comes in. A lower P/E means you’re paying less for your $1 or earnings.
‘Value’ investors rely on P/E. They seek companies that are cheap relative to their long-term prospects. They argue that lower P/E investments are undervalued. Studies have confirmed that lower P/E classes generate higher average annual returns.
So, what’s the ‘correct’ P/E ratio? Unfortunately, there isn’t one perfect figure. Instead, investors should consider the ratio relative to its industry. Some industries have lower average P/E ratios than others. For example, the coal industry sector has a P/E of 12. Why? It is a slow growth area. The world is moving to renewable energy and natural gas. Meanwhile, biotech has a P/E of 321. These firms develop new drugs and technology every year.
Seeking a low P/E ratio company is wise. However, be sure to compare the company to others within the industry. If you’re interested in a company that has a high P/E ratio be cautious. Ask yourself if you believe the company is worth the higher price tag? Are they poised for growth? Can they navigate the competitive landscape?
There is no ideal number. However, you can gauge relative value with just this one figure.
Annualised Total Return
Annualised total return answers one simple question: How’s your fund performing? Often this number is viewed in comparison to a broad benchmark like the S&P 500. Investors want to see if a stock has outperformed the passive approach of capturing the entire market.
The calculation represents the average amount an investment earned over a period. The calculation consolidates years of performance into one number. Therefore, it makes comparing investments easy. Be sure to compare annualised returns among like periods. For example, never compare a five-year annualised return with a ten-year.
For many investors a high annualised total return is exciting. However, it’s important to remember it’s all in the past. Tyco International, Enron, and HealthSouth are all examples of companies with stellar annualised returns. Eventually, they all crashed. The annualised total return alone is not enough. Investors must consider the number along with other metrics. Additionally, the calculation tells nothing of volatility. An unpredictable company and a stable one can look the same.
Annualised total return is a critical measure for ‘momentum’ investors. Momentum investors look to the past for clues on the future. The strategy is simple: pick winners because they’ll keep winning. Drop losers; they’ll keep losing. Does it work? There is some compelling research suggesting success. Findings in the Review of Quantitative Finance and Accounting, ‘provide strong new evidence of the investment merits of a momentum trading strategy.’ For ordinary investors, the figure simply shows how a company is positioned to enter the future.
A poor annualised total return may be more revealing than a strong one. If a company has failed to deliver a return, it will be difficult to change the trend. A business needs to make a big move if flat or negative performance is to change. Ask yourself if this is likely to happen.
The Sharpe ratio is a relatively new measurement. In 1966 William Sharpe developed the calculation. In 1990 he won the Nobel Prize in Economics. The number tells us how a stock performs relative to its risk. A higher Sharpe ratio is generally preferable. The reason: it means you’re getting more return for less risk.
All investments carry risk. The Sharpe ratio helps determine how well a stock can climb while managing the risk of falling. Investors use this number to understand how much return they’re earning given the risk accepted.
A high ratio doesn’t mean low risk. Rather, it means you’re adequately compensated for the risk. Also, a higher Sharpe ratio doesn’t mean a higher return. For example, a stock returning 12% in a year can have a lower ratio than one delivering 10%. Why? The stock with the 12% return took on more risk to get there.
How is risk defined here? The formula uses standard deviation. Greater volatility of returns is riskier. Imagine you’re about to go on a road trip. If you’re travelling off-road and hitting bumps the entire way, you have a low ratio. Take the paved road to the same destination, and you have a higher ratio. Investors want the smooth ride. The Sharpe ratio shows them if they’re headed for the dirt road or the highway.
The tool is powerful because it creates a relationship between risk and reward in a single number. Smart investing means smart risk management. Consider higher Sharpe ratio funds and stocks.
Remember, the measurement is more useful over longer periods. A Sharpe ratio for a one or two-year period won’t tell you much. Risk exposure increases over the long-term. Therefore, the ratio is more telling with regard to how the company withstands pressure over several years.
Like other measurements discussed here, there’s no ‘correct’ number. Instead of targeting a goal, consider how the ratio for one investment idea compares to another.
Putting It All Together
It’s easy to get lost in the numbers. Knowing the important ones saves time. If you consider these five, you’ll be performing a stronger analysis than most.
These metrics work best as a group. Consider each a single star adding up to a constellation. Remember, part of this image is more than numbers. Be sure to understand the fundamentals of the company in which you invest. You need to understand the value of their model. Ask yourself, can this company thrive in the future? Will competitive forces or technology jeopardise their earnings?
Lastly, the value of these numbers is that they rarely lie. Analysts and marketers can create any message. However, the numbers get straight to the point. Yes, companies can falsify and manipulate, but this will never change. These quantitative measures are the best shot at getting it right.
This article is for educational purposes only and should not be seen as financial advice.
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