|By: Andy George|
There are a number of key terms that investors should be familiar with. Though these terms are regularly banded about in many articles, they are not explained by many of the authors of these articles. The aim of this article is to explain a few more key terms which investors should be aware of when making their investment decisions.
The market capitalisation of a firm states how much the value of all the company’s ordinary shares is worth based on the current share price. Hence for example if a company has 1 million shares in issue and its share price is £2 then its market capitalisation would be £2 million.
This does not necessarily mean that is somebody wants to buy the company that he would be successful in acquiring the company at this price since it is usual for a premium to be paid above the current market price if someone wants to obtain control.
The nominal value of a company’s shares is the amount that by law is credited to the Share Capital Account of the company. It is not the same as the market value of the company. Hence in the above example if the nominal value of each share were 50 cents then £500,000 would be credited to the Share Capital Account. It is illegal for this amount to be distributed to shareholders in the form of a dividend.
PRICE EARNINGS RATIO
The most important ratio that investors should look at is the Price Earnings (P/E) Ratio. In layman’s terms this is the share price divided by the profit per share. The P/E Ratio of a Company should be compared against other companies in the sector and against the market as a whole. I also believe a good test is to compare the P/E Ratio of a company with other similar companies quoted on other international stock exchanges.
EARNINGS PER SHARE (EPS):
Another tool that should be used by investors is to look at the track record of the company concerned. By this I mean the growth (or lack of it) in Earnings per share. The Earnings per share is the profit per share that is earned by each ordinary share. A good management team should be able to register a solid annual increase in EPS on a consistent basis. Hence the general rule is that those companies that can show the market that they can register consistent growth in the EPS will do better from a share price point of view from those companies who have a patchy record with concern to EPS.
VOLUME OF TRANSACTIONS:
A key term that is mentioned in most financial report is the volume of transactions. This represents the number of transactions that have been carried for a particular security for a certain period. So for example if a Company has a volume of transactions of 5000 shares this can be interpreted in meaning that 5000 shares were bought and sold in that security. A general observation that can be made for most Stock Exchanges is that the volumes are greater in the larger companies and therefore the liquidity in these securities are greater than smaller companies. In addition, large volumes may arise in a security due to exceptional factors. For example large volumes may occur if there is a potential take over of a company.
If investors are looking for an indication of the Company’s short-term liquidity position then a key ratio is the Current Ratio. This measures the number of times its Current Assets cover its Current Liabilities. Though many textbooks generalise as to what the Current Ratio should be, I believe this is a mistake. The Current Ratio of a company will depend on the sector it is involved in. For examples Investment Trusts generally have high ratios due to the natures of their industry (i.e. few liabilities). However it has been observed that that the retail and hotel sectors generally have low Current Ratios. As a rule of thumb, the Current Ratio should be in excess of 1.5 times if it is to be satisfactory.
DEBT TO EQUITY RATIO:
The debt to equity ratio indicates how the capital structure of the company is formulated. A company that has a high debt to equity ratio is deemed to have a high financial risk. This is especially true where there is a recession in the economy. This could possibly lead to a downturn in the activity of the company with the likelihood that it will have difficulties in meeting its interest payments. If the company has a low debt to equity ratio then its financial risk will be low. What many investors may be asking is what is a good debt to equity ratio. The answer is that this will depend on the industry the company is in. In my opinion I believe that if an industry is stable (i.e. food industry) the capital structure can absorb a high level of debt. However if the industry were unstable it would be unwise for the company to have a high level of debt. As a rule of thumb I believe that a debt to equity ratio of 50% is satisfactory.
In my article I have tried to simplify terms that are used in various financial newspapers and journals. If one is serious about investing in the stock exchange I believe investors must grasp these terms.
Disclaimer: No responsibility for loss can be accepted to any person acting or refraining from acting as a result of material in this article.
COPYRIGHT: ©2004 by Andy George. All rights reserved
Publishing Guidelines: This article may be freely published so long as the author's resource box, by-lines, and copyright are included.
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