Helpful terms for investing in companies (PART 2)

In our last blog post, we talked about some terms you’ll come across when reading about investing and business in general. Next, we’re going to go a little deeper and look at some of the terms that are useful for analysing specific companies, and making investment choices around them. Let’s get into it:

Earnings per share

This is an easy one to start with. It’s the total profit a company has made, divided by the total number of shares. So if a company had 100 shares, and made $1000, then its earnings per share is $10.

This can be an important figure to look at because it really distills down how profitable a company is—and often, the more profitable a company is, the better. However, some companies may make no profit at all in their early days—so their earning per share is $0! But these companies may have more growth potential. As with everything, look at earnings per share in the context of your wider goals and investment approach. Earnings per share tells you how profitable a company is at the moment, but some companies have low earnings per share now because they’re looking to create higher earnings per share in the future.

Price-to-earnings ratio (P/E)

The next term is the price-to-earnings ratio. This is the share price divided by the earnings per share. This is important because it shows how much you’re paying for each dollar of income. A company may have high earnings per share, but low P/E, because the share price is quite high.

Dividend yield

Dividend yield is the percentage of the share price that the company has paid out in dividends in the past year. This is helpful for making estimates as to what kind of return on your investment you might get.

So, if a company’s shares were $1 each, and it paid 10 cents per share last year, then its dividend yield would be 10%. If they were $2 each, and it paid 10 cents per share, its dividend yield would be 5%.

In this way, dividend yield is kind of similar to the P/E ratio—the dividend yield can go down, even if the dividend doesn’t change, if the share price goes up. The reverse can happen as well. With this number, it’s also important to note that what a company did last year may be quite different to what it will do this coming year. Whilst it is often a good guide, it is now like a Term Deposit interest rate.

Market capitalisation

This is how much a company is worth, in total. You find it by multiplying the share price by the total number of shares. This is useful because the number of shares plays a big role in determining how much a company is worth. After all, if you had a company with just one share, for $1,000, it would be worth a lot less than a company with 1 million shares that cost $1 each. So market capitalisation is really useful for comparing two companies against one another to figure out which one is more valuable.

Equity

Companies are basically built out of two main things: assets and liabilities. An asset is something the company owns that has value, like a machine, land or a brand. A liability is a debt owed by the company—like a bank loan, some existing bonds, or even money promised to employees and suppliers.

The equity is the total assets, minus the total liabilities.

A good way to think of this is to compare it to your personal finances. If you had $10,000 in the bank, but had a personal loan of $20,000, your total equity would be negative $10,000. On the other hand, if you had $5,000 in the bank, and no debt at all, your total equity would be $5,000.

But like everything, equity isn’t the whole picture. Think of your personal finances again: you might have $10,000 in the bank, and a $30,000 student loan. However, a government student loan has some pretty attractive terms—no interest, and repayments based on your income. So while the equity situation might be a bit dire at the moment, it may also pay off in the future as you pay down the loan and enjoy higher earning power from your education.

It’s the same with companies—some companies may have low equity at the moment, because they’re trying to invest towards growing in the future.

Return on equity

Equity is essentially the total amount of money a company has invested. So you can use its earnings to calculate its return on equity. If a company’s equity is $100m, and it made $10m this year, then its return on equity is around 10%.

This is a really useful tool, because you can compare a company’s return on equity to what it could have made by investing elsewhere. For example, term deposit rates are around 3%. If a company has a return on equity of less than 3%, you might wonder why it bothered—it could have sold all its assets, put the money in the bank, and made a better return on equity. Of course, it could just be going through a rough patch, or investing in future growth, but it’s worth figuring out the return on equity in order to ask these questions.

Earnings before interest, tax, depreciation and amortisation (EBITDA)

This one looks complicated, but it really isn’t. Earnings are pretty straightforward—they’re the revenues a company has made, minus its expenses. However, lots of people prefer EBITDA because it “strips out” some things that can be distracting.

For example, let’s say you had two companies. One made $1m in profit by selling things to its customers. The other made $1m in profit by selling $800,000 worth of things to its customers, and another $200,000 by putting a spare $6.6 million in a term deposit with a 3% interest rate for a year.

If you just looked at profit, these two companies would look the same. But if you looked at the EBITDA of these companies, the first one would have $1m profit, while the second would have $800,000...$200k less! EBITDA helps to remove all these other sources of income and expenses, and gives you a clear view of what the business is actually capable of producing. After all, anyone with money can put it in a term deposit—it’s much more impressive for a company to make money by actually making things and selling them to people.

The downside of EBITDA is that it can “hide” expenses. For example, if you had a company that owned a factory that needed to be replaced every 20 years, you would see 1/20 of that factory’s value as an expense on their annual report every year—this is called depreciation.

EBITDA would remove this expense, which may make the company look more valuable than it is. After all, the company still owns the factory, needs to maintain it, and will need to replace it someday. So, like everything, make sure you understand what you’re looking at when you look at EBITDA. It has some strengths, but it also has weaknesses.

It’s about the mix

These are just a few terms you might run into when you’re reading up on companies to invest in. The key thing to remember is that none of these terms gives you a perfect view of a company, and none of these terms can immediately tell you if the company is worth investing in. Rather, you need to understand what these terms are telling you, compare them against each other, then think about your investing approach, goals, time horizon and so on.

And remember, there are other ways to choose a company to invest in. Some investors invest without looking at any figures like this at all! For example, people invest in companies they want to see succeed, or companies they enjoy doing business with, or companies whose values are in line with theirs—you can invest based on any criteria you want. The actual decision about where you put your money is completely up to you!

Ok, now for the legal bit

Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written.