Sometimes it can feel like finding high quality shares is very complicated. While it’s often best not to oversimplify and just try and buy everything that sounds good at any price, there are ways to identify potentially great shares that don’t necessarily require expensive software, an A level in maths, or even a lot of time.
These five ratios or calculations below will go quite a long way (although further research would be advisable) to assessing whether a share might be worth investing in, or at least if it shows signs of being a high quality company.
The five ratios
The Return on Capital Employed, or ROCE, measures how effectively a company uses its total capital employed to generate income. It is calculated as the Operating Income divided by the Capital Employed.
It’s a really good measure of quality. A higher ROCE is good but not everything. A company that has a low ROCE that is increasing could be worth looking at just as much as a company that has a consistently high ROCE. In one case there might be a turnaround which could unlock significant value, in the second example the business may have a moat protecting the business, or just management very capable at capital allocation – something Warren Buffett considers to be very important.
The Operating Profit Margin is a measure of how much income a company has left after paying its operating costs such as rent and salaries. It is calculated as operating profit divided by revenue.
High margins in my opinion offer protection against pricing pressures, increased costs and just generally an uncertain future. Investing in low margin businesses can be fine but what happens if a company only makes 2% operating margin and then one day it’s costs go up 20% – in short: nothing good. A high margin offers a buffer against these unforeseen shocks.
The flip side is that high margin business inevitably attract competition, which if there is no enduring moat around the business can erode margins and likely the share price with it.
Debt to equity
This ratio looks at how much debt a company is using to finance its operations. Analysts and shareholders deploy the ratio to assess the impact of leverage on the company’s balance sheet. Debt-to-equity can be calculated by dividing total liabilities by shareholders’ equity.
Some industries just operate with higher debt levels so it’s worth bearing that in mind but as a rule of thumb the lower the better. Debt is just another cost which means less money going to shareholder and/or being invested I the business to create future growth.
The P/E to Growth ratio, or the PEG, was popularised by both Peter Lynch, author of the classic One Up on Wall Street, and in Jim Slater, Zulu Principle. The PEG is calculated by dividing a company’s P/E ratio by its expected EPS (earnings per share) growth rate for the coming year. Slater looked for a PEG of 0.7 or below, which indicated that a share may be undervalued given its future growth potential.
The Quick Ratio is a measure of how many times a company can pay its current liabilities using its cash only. It is calculated as cash divided by its current liabilities. It offers a more stringent measure of liquidity than the current ratio. This is calculated on a historical basis.
What else might be worth looking at beyond the five measures?
- Management holdings
- Director dealing
- Cash flow statement
- Industry trends and changes
- Dividends (if applicable)
- SWOT analysis
Other qualitative measures such as competition, the potential for growth, director buying and selling and there are endless things that could be researched.
It all depends on how much research you’re willing to do before buying a stock. There’s a tricky balance between doing enough research and not allowing that research to lead to procrastination. Hopefully an understanding of these important investing ratios will help a little. If it does, please leave a comment – it’s great to hear from readers.
If you liked this article, you may also like the article on five ways to find great dividend paying shares.