Two financial ratios to consider when choosing shares

In this edited extract from her book Shareplicity Danielle Ecuyer reveals the two key financial ratios you should consider when choosing shares and what they tell you about a stock.

Two financial ratios, calculated from the earnings a company generates, are used universally and provide a basis of valuing shares for investors. These are the two that you need to observe and understand to assist you to make the optimal share purchases:

1. Earnings per share (EPS) – this is an allocation of how much net profit is attributed to each share.
2. Dividend per share (DPS) – the actual cash payment the shareholder receives, normally twice a year.

For most of us, EPS is quite an abstract concept. Here’s a good analogy: a vigneron plants a grapevine. The vine isn’t planted with the expectation that the vine and the grape harvest will stay the same as time progresses. Each year the vigneron works at enabling the vine to grow more stalks and stems, and with each new stalk and stem, more grapes will be produced.

The growth in the stalks and the stems are the EPS growth, so to speak, and the grapes yielded are the DPS. It’s the same for a share: you aim to buy shares that deliver good growth in earnings (vine stalks and stems) so that you receive a higher value for the vineyard based on the higher production capacity. Along the way the higher dividends (the grape harvest) deliver the income gained from holding the share.

Earnings per share

Earnings per share is the net profit divided by the number of shares listed on the stock exchange. It’s important as it provides the basic number that’s compared to the share price to value the share. You want shares that can grow their EPS consistently. As the earnings grow, the share price appreciates in value, reflecting the higher EPS. Conversely, when the EPS falls, the share price will also fall. That isn’t what you want.

Dividend per share

The DPS is the amount paid to each shareholder out of the EPS. It’s the reward for shareholders who invest in the company and is paid twice a year. Unlike the share price rise for growing the EPS, the DPS is real cash in the bank. EPS is capital gain and dividends are income. The dividend is important for investors who want an income from their shares. Dividend payments also provide a solid buffer for you when sharemarkets fall.

You’ll often hear commentators referring to the benefits of dividends when sharemarkets are going down or flatlining or moving sideways. Dividends are paid at the discretion of the management and board of the company and may even be suspended. Dividends are not a “right” for shareholders.

Should you buy shares for income or growth?

So, should you buy shares for the dividend only (income) or for the capital appreciation in the share price (known as growth)? The answer is, it depends on you. What do you want from your shares? It often depends on what stage you’re at in your life. For example, if you’re retired you might rely on dividend income to live; if you’re younger you may want to buy shares that pay a low to zero dividend because they’re growing the EPS so strongly.

Some investors often see it as an either/or scenario, but the truth is that it’s always better to invest in a share with some dividend payment. Dividend champions are important for creating long-term wealth but if you’re simply chasing dividends you may be disappointed when the capital invested falls. Australian share investors benefited for many years from a high income on some of the most popular shares. However, this strategy has become more complicated because of a changing regulatory and competitive market.

This is an edited extract from Shareplicity: A simple approach to share investing (Major Street Publishing $29.95), exclusive to Canstar, and republished with permission.

About Danielle Ecuyer

Danielle Ecuyer has pursued a successful career in Institutional Equities Stockbroking and Wealth Management for 15 years after completing her Commerce Degree at the University of New South Wales. She trained and worked as an Australian equities analyst for BZW Australia in Sydney, laying the foundations of fundamental share analysis. After moving to London she transitioned her expertise to Institutional Emerging Markets. She returned to Australia in 2003 and since then, Danielle has used and expanded her skills for her own investment portfolios covering the Australian and US Markets. Her latest venture is Shareplicity, which is a simplified approach to share investing and the basics involved in managing the opportunities and risks of 21st Century investing.

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Main image source: JohnKwan (Shutterstock)