Simply put, this measure is the price that investors are willing to pay for the profits, or earnings, at any given company. So, for example if a company is generating a £10 profit and the shares are £100, then the price to earnings ratio is 10.
The basics of the PE ratio are easy to grasp, the more important thing to remember is that as an investment indicator it is a weather vane rather than a compass and should be used as a guide rather than an absolute buy or sell indicator.
A PE of 10 is not automatically cheap, nor is 20 necessarily expensive. Sometimes the shares can be sold as the market becomes extremely negative on a company’s prospects, causing the PE ratio to fall.
When this happens and there has been little or no change in the profitability that is where opportunities arise.
Oil giant Shell is a good example. The shares at £20.68 today have fallen more than 16pc in the past six months as the oil price has dropped sharply. That means the shares trade at a PE ratio of 14, which is a discount to the wider FTSE 100 on 16 times.
The shares offer good protection from a market sell-off having dropped to a floor of about £15 in the darkest days of the 2008 financial crisis and around £13 in 2003 after the dotcom bubble burst. It suggests a floor of 25pc to 30pc of losses. The shares offer a prospective dividend yield of 6.2pc.
What’s more, Shell has one of the best dividend records in the FTSE 100. It is a share to hold forever.
This is another favoured way to find shares. It can highlight overlooked companies that are generating plenty of cash and returning it to shareholders.
There is, however, a caveat. When a yield approaches 7pc the market is probably expecting a cut. But the market is not always right, so investors can often lock in great dividend yields if they keep an eye out for sudden share price falls.
A classic example is Imperial Tobacco, which is expected to pay £1.43 per share in dividends this year, or a yield of 4.6pc, at the current share price of £31.32. It is another share to hold forever. As all wise investors know, the power of dividends re-invested is immense (see here).
The PE ratio and the dividend yield are the best guides to find investment ideas. The best way to protect against losses in your investments is by looking at the balance sheet. Too few investors do.
Working out the net asset value (NAV) per share from the balance sheet, also known as book value, allows investors to understand the margin of safety in buying the shares at today’s prices. The NAV is a rough estimate of what the company would be worth if it went out of business tomorrow. Taking a company like Royal Mail, the most recent NAV was £2.7bn, so with 1bn shares in issue, that works out at a NAV of about £2.70 per share. Royal Mail shares, trading today at about 430p, look reasonably priced on 1.6 times the NAV, when compared to the FTSE 100 average of 2 times.
This measure shows if a company is turning sales into cold hard cash. Some of the most successful companies have gone out of business because they reported rapid growth in sales but didn’t collect the cash necessary to pay the bills. Ideally a company will have very similar profit and cashflow figures each year.
A good example is consumer goods giant Unilever. The company recently reported operating profit of €7.98bn (£5.7bn) and cashflow of €7.85bn, meaning it collected nearly all its profits in cash. The excellent cash collection makes the 3.2pc forecast yield very secure and a good reason Questor likes the stock.