Personal finance: How to work out whether a firm's figures add up

Understanding the stock market

Shortly before Christmas, we looked at the p/e, which is the price- earnings ratio, one of the traditional tools used to assess a share's worth. The ratio is a simple concept and is calculated by dividing the company's share price by its earnings per share.

It is sometimes referred to as the "confidence ratio". As a general rule, the higher the p/e, the higher the market's regard for a company. Of course, only time will tell whether the market's judgement is correct. Certainly, investors should not use it in isolation when making their investment decisions.

For example, two companies may have identical p/es, based on present eamings, but one has far better prospects for growth and consequently an increase in share price.

The problem with the p/e is that is a measure which is essentially one- dimensional. It is the relationship between the p/e and the expected growth of a company's shares which is a more meaningful measure.

A relatively new investment yardstick is the price earnings to the growth factor, which is known as the PEG. It relates the expensiveness of a share - that is the p/e - to the value to be received in the share price - that is the earnings per share growth rate. Let us take a look at how the PEG works in practice.

Suppose a company's p/e is the market average of around 15. If its earnings grow by 10 per cent a year, its PEG will be 1.5. If its earnings grow by 15 per cent, its PEG will be 1, while an earnings growth of 20 per cent will result in a PEG of 0.66.

The general rule is, that providing the other fundamentals are satisfactory, the lower the PEG, the better the prospects for growth. Therefore, investors seeking growth shocks should ideally be looking for companies for a PEG of 1 or less.

Perhaps one of the most important investment yardsticks is the return on capital employed. This is simply a company's profit before interest and tax, divided by its net capital employed (also referred to as shareholder's funds) and then expressed as a percentage.

Therefore, a company with a profit before interest and tax of pounds 1m with a capital employed in the business of pounds 5m, has a return on capital employed of 20 per cent. The fairest approach is to use the average of the capital at the beginning and end of a financial year.

The return on capital employed may be used to compare the efficiency of similar companies as well as those in most different lines of business.

Naturally, the trend of this ratio is important, but its level at a particular moment in time is significant. If a company is not making a return on capital which is sufficient to comfortably cover the cost of its borrowing, then clearly it is heading for trouble.

The long-term financial health of a company normally requires returns on capital to be well into double figures. Indeed, returns of 20 per cent or more are not uncommon amongst the market's most efficient companies.

Care should be used when looking at this yardstick for companies with significant assets in property which are revalued on a regular basis. Upward valuations have the effect of reducing the return on capital employed. Therefore, any conclusions from trends in the ratio should be viewed in the context of the revaluations.

An increasingly important yardstick for assessing the real worth of an investment is "cash flow". This is because when it comes to the daily operation of a company, cash flowing through a business can be more important than the conventional accounting measures of profitability. Cash flow is the most important measure of value created by a business.

The annual reports of all companies include a cash flow statement. Although the statement splits the cash flow into different categories, in essence it is designed to show how the profits are spent and where the money goes.

This is important as it is a check that the earnings of as company are backed up by hard cash. The "free" cash flow, which means after dividends and capital expenditure have been taken into account, funds the company's future expansion.

When you look at a cash flow statement, there is a great deal of information to absorb. However, of all the data, the most critical is to ensure that the net cash inflow from operating activities is not materially different from the profit produced by trading operations.

When the cash flow from operating activities is less than the operating profit, creative accounting may have been employed. You should be cautious.