Finding quality investments

21 Jan 2013

By Shadforth Financial Group 

Finding quality investments is like looking for a needle in the hay stack. It is something that many people look for but few find over the long term.

Professionals use a number of tools to assess what is and what isn't a quality investment, these tools include:

Earnings per Share (EPS)

This represents the portion of a company's earnings that is allocated to each ordinary share of the company. The figure is usually calculated simply by dividing net income earned in a given reporting period (usually quarterly or annually) by the total number of shares outstanding during the same term.

The earnings per share is usually used as a guide to a company's profitability per share and what you need to look for is an average annual growth in EPS of 8%+ over a three to five year period.

Return on Equity (ROE)

This ratio is the profit made by the company as a percentage of the shareholders funds. In other words this measures the return shareholders receive on their investment. So, if the company's profit for the last year was $200million and the shareholders' funds invested in the business were $2,000 million, the return on equity is 200 divided by 2,000 = 10%

The higher this percentage is the better and in any good company this return will increase over time. The legendary Warren Buffett always aims for a return on equity of 15%+.

Return on Assets

This ratio measures the profit made on a company's assets and is calculated by dividing the earnings before interest and tax (EBIT) by total assets. Anything less than 6% is usually a cause for concern.

Price Earnings Ratio (P/E ratio)

The Price Earnings ratio is probably the most used financial ratio used to analyse and compare companies.

The calculation is made up as follows:
P/E ratio = market price / earnings per share

The P/E ratio in simple terms is the number of years based on current earnings that it will take for a share to pay for itself.

It is worth noting that an abnormally high or low P/E relative to peer companies will indicate typically that the company is over or underpriced by the market, respectively.

Whilst it is the most commonly quoted financial ratio, it has a major problem in that the earnings figures used are usually past earnings. To overcome this problem, many analysts use prospective P/E ratios, however these inevitably change over time.

With these tools, professionals are looking for investments that are:

  1. Growing over time
  2. Have strong management
  3. Has a low level of debt
  4. Attractively priced
  5. Have a competitive edge

The risk with this approach is that what has traditionally been a great investment in the past may not necessarily be a great investment in the future. The world changes and you need to ensure that you adjust your investment portfolio accordingly.

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