3 Financial Metrics to Help You Identify Winning Shares

Have you ever wondered how successful investors like Warren Buffett and Peter Lynch have managed to make their pot of gold in the share market? Turns out the answer is contained within a very simple phrase: “Invest in businesses, not tickers.”

The share market is filled with people who gaze at share prices in an attempt to predict how those prices might move over the next couple of days, or hours, or (gasp!) minutes. However, the effort spent on such endeavours often amount to nothing except a little entertainment, perhaps.

The key point about the share market is to understand the underlying business fundamentals of a share and see if the company is doing well. But, this would naturally lead to a question. There are more than 700 companies listed in Singapore’s stock market and it would be extremely time-consuming to go through them one by one. How can the process be streamlined?

To help with that, I have previously highlighted certain qualitative aspects of a business you could be looking at. Now, I have here three popular financial metrics which can be used as filters that could assist you in your search for great investments:

1. EPS growth rate 

The growth rate of a company’s EPS (Earning Per Share) measures how well it is growing its earnings. It is an important metric to track because it is often the case where capital gains in a share would follow with an increase in EPS. In fact, my colleague Ser Jing had done some research on Singapore’s best and worst shares over the past decade (see here and here respectively) and showed how there are strong links between a company’s growth in profit and share price gains.

But besides a strong rate of growth in EPS, consistency is important as well; a company that has a huge but unsustainable jump in EPS in just one year would likely not make for a very attractive long-term investment opportunity.

Meanwhile, a firm that could deliver an annual EPS growth rate of 10% or more over a long stretch of time (say a decade or more) would likely have a strong business that can continue to deliver in both up or down markets.

2. Return on equity

A company’s return on equity (ROE) measures how efficiently it utilizes shareholder’s equity to generate profits. Mathematically, it is represented by a simple formula whereby a company’s net income is divided by the average shareholder’s equity over the timeframe in question.

The use of a company’s ROE in finding great investment opportunities is often linked to Buffett as he uses the figure to quickly analyze whether a company has managed to consistently perform well when compared to rivals in the same industry.

3. The P/E ratio

Lastly, the P/E (Price to Earnings) ratio is probably the most frequently-used indicator for a feel of how expensive or cheap a share is.

A quick and simple guideline on a possible way to use the metric would be to take a company’s P/E ratio and compare it against the average P/E ratio, over the past few years, of the industry it belongs.

The point behind calculating the P/E ratio of a company is to have an idea of the price the market is willing to pay for the company’s earnings.

With a high P/E ratio, it generally means that the market has high expectations of future growth for a company – a company may thus be overvalued if its future performance falls short of those high expectations.

Meanwhile, a low P/E ratio indicates that the market has very low expectations of future growth. In this scenario, a company may be undervalued if its eventual corporate performance exceeds those low expectations.

A Foolish filter

With the above in mind, I ran a screen on Google Finance’s free stock screener using these three parameters: 1) A 5-year average ROE that’s above 15%; 2) an annualised EPS growth rate over the past 5 years that exceeds 10%; and 3) a share that has a PE ratio of between 5 and 15. Some shares that managed to pass through the screens include Keppel Corporation (SGX: BN4), Lian Beng Group (SGX: L03), and Valuetronics (SGX: BN2).

None of this is to say that those three shares will definitely be long-term winners. Instead, such a filter is to help you narrow the universe of publicly-listed companies into a more manageable bunch from which you can then pick and choose the best opportunities available.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.