The Motley Fool

3 Ratios to Use When Analysing Investments

There is admittedly a lot of work involved in researching and properly analysing a company for investment. Investors need to sift through a large amount of material and read through many reports in order to get a sense of how attractive a company is as an investment. This takes effort, patience, and time.

However, I have learned how to shorten the process by relying on a few simple yet effective ratios when screening for great investment ideas. These ratios provide an investor with a quick look at how attractive or risky a company is so he can choose to do deeper research, or to move on to a better opportunity. The investor can add these ratios to his investment toolkit in order to shorten his investment search time and relieve some of the burden involved in screening for investment ideas.

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Return on equity

Return on equity (ROE) measures the profitability of a company per dollar of capital. The formula is derived by taking the company’s net profit after tax (NPAT) divided by its share capital base. A higher ROE indicates that a company is more effective in converting each dollar of capital into profit.

Companies with high ROEs make attractive investments as they are able to compound an investor’s capital significantly over the long term. My own rule of thumb is to look for ROEs above 15% when I screen for investments.

Debt-to-equity ratio

Looking at the ROE alone may not always paint a full picture, as high debt levels may boost a company’s ROE and give the illusion that the business is generating high returns. Investors therefore also need to look at the debt-to-equity ratio in order to ascertain if debt levels might be too high with respect to the share capital of the company.

The debt-to-equity ratio (DER) is computed as the total gross debt of a company divided by its share capital. It measures the amount of debt per dollar of equity. My usual rule of thumb is for a 50% DER to be considered acceptable, with anything exceeding 100% being labelled as “risky.”

Dividend payout ratio

The third useful ratio is the dividend payout ratio (POR). This is found by dividing the dividend per share (DPS) by the earnings per share (EPS). The POR shows us how much of a company’s earnings are being paid out as a dividend, and it also tells us the proportion of earnings that are being retained for growing the business.

Suppose a company has a POR of 40%. This means it’s paying out 40% of its earnings as a dividend, while the remaining 60% is retained to grow the business. The POR level provides a good indication of whether or not the company has room for growth. A POR of 80% to 100% implies that the company is paying out almost all its profit as dividends, signifying little or no growth left. Conversely, if a company’s POR is just 10% or 20%, that means it’s retaining the majority of its profit to further grow the business.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.