03 December 2012

Introducing Simple Financial Ratio - Part 1

There are several posts related to shares investment which I wrote earlier on and you may take it as your reference. Now, I would like to share with you on how to compute a simple financial ratio which I learned from CFA program. 

P/E Ratio = 

PE Ratio is derived from two parts - Market Share Price and Earning Per Shares (EPS). The formula is shown as below: 

P/E Ratio = Current Market Price 

You could get two ratio, Trailing PE Ratio and Forward PE Ratio. Trailing PE Ratio means that it is derived from the history EPS and current Market Shares Price. Forward PE Ratio is derived from estimated EPS (next year) and current Market Shares Price. 

Normally it is better we can use forward PE ratio as compared to trailing PE ratio, as it could be an advanced indicator to check the future price movement. Of course, we must take into consideration all the ratio or factor before we make an investment decision. 

The lower the PE ratio, the better the figure is. This is only apply to counters compared to its peers. Of course, it could also indicate that this counter could have higher underlying risk which the market determines. So before making any investment decision, it is better that you could do a thorough investigation on the company to make sure it will not bankrupt or suffer from a structural change in the sector. 

P/B Ratio = 

P/B Ratio is derived from Current Market Price and Book Value. Again, you can get two different ratio, Trailing P/B Ratio and Forward P/B Ratio. To me, I prefer to use average of Trailing P/B Ratio and Forward P/B Ratio as I tend to not to over estimate or under estimate both ratio, so I would like to use the middle of both figure. 

P/B Ratio is one of the important indicators for sectors which utilize a lot of Non Current Assets to boost up their revenue. The more Book Value, the better the the revenue and profit are. Few major sectors such as Utility, Telecommunication, Property Development and/or Industrial sectors rely on non current assets to further improve their profitability. 

However, to me, P/B Ratio is not a very good indicator for Finance Industry. Why? It could be due to the finance industry relies more on Non Assets, such as the management quality / distribution networks / staff execution power / corporate culture etc to perform or to achieve a better result among it peers. So you can see why Public Bank enjoys a higher P/B Ratio among its peers to due better quality of bad debt ratio and good execution power from the management. 

D/Y Ratio = 

Dividend Yield Ratio is derived from two figures - Dividend Per Shares (DPS) and Current Market Share Price. The formula is shown as below: 

Dividend Yield = Dividend Per Shares (DPS)
Market Price

To me, the higher the better. But again, you have to check all the factors before you make an investment decision. Some investors who look for higher D/Y Ratio should be aware of the consistency of the dividend payout Ratio or consistency of the dividend per shares paid to the share holder, so that you will not be trapped to the high D/Y Ratio due to special dividend given or it could be due to the company is in the peak profit period in few years time and the prospect is not looking to good in near future. 

ROE Ratio = 

ROE Ratio is one of my favorite Ratio = Earning Per Shares and Equity. The simple formula is shown as below:

ROE =   Earning Per Shares 
            Equity Per Shares

If you do not really how why it is important. Let me share with you a short story. Now, Ah Beng likes to setup a small sole proprietorship. As he does not have negotiation power to deal with bank, he had to take out money from his own pocket to start up the business - Hawker ABC. He took out S$50,000 from his own personal bank account and rent a stall at Jurong East. After deducting all the expenses, he managed to get S$1,500 a month. So after a year, the ROE for his own is $1.5K*12 / S$50K = 36%

Can you see a difference ROE of 30% compared to ROE of 10%?

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