There’s more to building the right portfolio than going with your gut feel. You need to understand the field by being familiar with the terms, know what contributes to a company’s value, what could affect your investment and what helps grow your portfolio value.

The three levels of profitability

Gross profit

This is the simplest calculation as it reflects total sales less the cost of sales, but doesn’t take into account operating costs, debt or tax.

Operating profit

Operating profit is a measure of a company’s operating efficiency as a whole, including all the expenses it incurs in its daily business activities.

Net profit

The bottom line profit that reflects the income left after all expenses are paid, including interest and tax. This is where dividends come from.

Headline earnings per share

This is a measure of the total operational and capital investment earnings of a company, divided by the number of shares in issue.

Price earnings ratio and what it means


What is the PE ratio?

The ratio of the share price to the latest full year’s profits of the company per share (Headline earnings per share or HEPS).

What can it tell me?

It quickly shows if a share is cheap or expensive relative to the comany’s peers, based on past earnings.

High or low PE

A high PE usually indicates the market is expecting growth from the company. A low PE may indicate the expectation of poor future performance.

When to use it?

PE ratio is most often used by value investors. It essentially shows the number of years a company will take to be worth the price you’ve paid.

The Price Earnings Growth ratio puts the Price Earnings ratio in context


What is the PEG ratio?

Will tell you if a high PE ratio simply means a share is expensive or reflects strong growth prospects for the company.

How to work out PEG?

It is the PE ratio divided by the company’s percentage earnings growth (growth in HEPS) for a specified period.

Why is it useful?

It takes into account growth prospects, so is a more complete view of whether or not a share price is expensive.

Why is it risky?

PEG relies on earnings forecasts, which have a wide margin of error. This may be caused by things like an unexpected currency movement or economic slump.

Other important indicators for analysis


Dividend yield

Not all companies pay dividends, often for good reason. Dividend yield is the dividend paid expressed as a percentage of share price.

Growth vs value

A dividend yield, like a PE ratio, is used as an indicator of “value” versus “growth” companies.

Net asset value

The book value of the company, after all liabilities have been deducted from its assets. Does not consider cash flow or earnings prospects.

The enterprise multiple or ratio

Net asset value divided by Ebitda gives a better measure of a companies value than PE ratio as it is not affected by changes in capital structure.

Return on equity


Return on equity

Divide the headline earnings by shareholders equity. This removes any once-off statement items to capture sustainable earnings before dividends are paid out.

Why is RoE important?

It shows how well a company is using shareholder’s money, and depending on the industry can be a useful input to guide forecasts of a company’s growth.

Du Pont formula

Breaks down return on equity into three different parts to better analyse what causes changes to it over time.

The problem with financial ratios

No two companies prepare their financials in exactly the same way, so there can be discrepancies in which figures you use to build your formulas.

Cash flow is everything


What is cash flow?

The flow of actual money in and out of a company. It’s one thing to make a sale, and another to ensure the money actually comes in.

Operating cash flow

The money that comes in from customers, and that goes out to suppliers.

Investing cash flow

An indicator of investments in new factories and machines, subsidiaries, any financial instruments like bonds and shares in other companies.

Why is cash flow important?

It is an important measure to verify what a company is reporting in its financial statements. Examine the sources of cash though.

Cash flow ratios to consider


The cash ratio

This tells the quality of earnings. It is the cash generated, as a percentage of the operating profit. Lower than 100% shows a company operating on credit.

Cash flow coverage

This is cash from operations over total debt. This is useful for lenders or to determine if a company is conservative.

Free cash flow

This is the amount of cash available to distribute to shareholders.

What about future cash flow?

Money currently in hand is worth more than the promise of future money. We discount this cash to give it a present day value.

Discounting cash flow


How do you discount cash flow?

A discount is applied to future cash flow to give a current value. This is one of the most important ways of estimating a company’s intrinsic value.

Estimate future cash flow

Is the company investing in future growth? Can it increase prices or margins? How might this affect future earnings and cash flow?

Estimate the discount rate

Two factors to consider are current interest rates and a risk factor for investing in a particular industry.

Calculating the discounted value

Discount the present value by the discount rate and time expected.

Profiting from risk


Risk versus returns

There is usually a correlation between risk and return. The higher the expected return, the higher the risk. Aim for maximum returns with low volatility.

Equity market risk

Combine different assets to form portfolios that minimise variance while maximising return.


This measures the underlying risk in a share. Understanding the Beta of shares in your portfolio will help balance the overall risk present.

The Sharpe Ratio

This ratio tells us how much return is generated for each unit of risk. It is a reward to variability ratio.

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