While there’s no single ‘right’ way to buy ASX shares, the key to maximising future returns is to understand a handful of financial ratios, plus some other key indicators.
Do this and you’ll significantly improve your ability to buy the right shares at the right price.
No single piece of data should ever be looked at in isolation. The smarter approach is to draw from a handful of criteria to get a much better snapshot of a share’s overall health.
Let’s take a look-see at the financials.
1) Price-to-earnings growth (PEG) ratio: A combination of the price-to-earnings (PE), divided by the prospective earnings-per-share (EPS) growth rate gives the PEG ratio, which measures the price of earnings growth.
Ideally, you should be looking for a PEG of less than one. Tip: the lower the PEG ratio, the more a stock may be undervalued relative to its future earnings expectations.
2) Price-to-earnings (P/E) ratio: Contrary to the popular belief, P/E is not a measure of absolute value. As such, it can often raise more questions than it answers.
However, a share’s P/E – which is its current share price divided by its earnings per share (EPS) – provides a useful starting point for comparing different shares within like or similar sectors.
If you’re hell bent on using P/E as a measure, you need to understand: A) why it might be low, relative to its peers; and B) the outlook for the next 12 months.
If you don’t understand these 2 factors, you risk buying value traps, which will drag down your overall portfolio performance.
3) Payout ratio: As a percentage of net profit paid out as dividends, the payout ratio is an important proxy into the sustainability of a company’s dividend.
It also provides strong clues into a company’s future growth upside. A payout ratio less than 50% can also signal that the company plans to use surplus cash to grow the business.
4) Return on equity (ROE): A key measure of how well management uses its equity, ROE is earnings (revenue minus expenses, taxes and depreciation) divided by equity.
As long as debt remains controllable – ideally with a net-debt to equity ratio under 70% – there’s no better indicator of business performance than the ROE.
Another way to look at ROE is to ask whether or not every $1 used in financial growth is able to convert into $1 of market value.
5) Return on investment capital (ROIC): Measures the cash rate of return on the capital that a company has invested. In some cases, it’s modified by replacing earnings with earnings plus the interest on long-term debt.
In this case, a comparison with return on equity (ROE) determines whether the company benefitted from the extra debt.
Assuming the return on equity (ROE) is higher than ROIC, the debt has succeeded in adding value to the business.
6) Earnings per share (EPS) growth rate: Within normal markets, share prices typically increase if EPS increases. And the faster a company grows its EPS, the higher those earnings tend to be valued.
It’s important to overlay the above key financial ratios with some important measures of growth and value.
Digging around in the annual report can provide valuable insights into:
7) Management’s track-record and industry knowledge. One key element to look for within managements’ talents is evidence they’ve carved out a sustainable competitive advantage for the business.
Without it, a company can’t generate long-term, above-market returns.
8) Sales activity: There’s no room for BS here, either a company’s revenue has tracked upwards over the long-term or it hasn’t.
If not, why not, and more importantly, ask when did the rot set in?
9) CAPEX, staff numbers and R&D: You want to see sufficient evidence that the company is investing in future growth – this includes its staff.
If there is no evidence of sufficient investment, then ask why not, and equally important – when did the wheels start falling off?
10) Structural growth: Unlike cyclical growth, which is vulnerable to the economic cycle, you want to find out how much structural growth is being driven by what’s happening inside the business.
A shift or change in the basic ways a company functions or operates can signal that it’s serious about applying new technology or adopting to regulatory or industry-changing reforms.
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