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Thursday, April 3, 2008

The Science of The Stock Market

The first one you need to look at is the Dividend yield.

A dividend is the money paid on each share from the company`s net profits. Small companies often don`t pay dividends ? they plough their profits back into growing their business. But if a large company doesn`t increase its dividend or cuts it, you can bet it needs the money simply to survive. As the share price falls though, the dividend yield (dividend compared against share price) will rise. This could make the stock a relative bargain.

The second and most important ratio is the Earnings per Share or E.P.S.

It represents a company`s post-tax profits divided by the total number of shares in issue. Generally, an E.P.S. higher than the cash flow per share (shown on the cash-flow statement in the company`s annual report) indicates a company with strong value. A steadily rising E.P.S. indicates financial health and growth.

The next ratio is the Dividend Cover.
This tells you whether a company can afford to pay its shareholders their dividend or not. Divide the E.P.S. by the dividend announced by the company. The result should be 1 or higher. If it`s less than 1, avoid it. The firm hasn`t got the cash to pay its dividend and is digging into cash reserves.

The fourth ratio is the Price-Earnings Ratio or P.E.

It`s calculated by dividing the share price by the earnings per share. If you`re investing for the mid to long term, look for shares with a low P.E. compared with other firms in its sector. If you want a fast profit though, you could buy a stock with a high P.E. Although these shares are overvalued, the price will have upwards momentum. Investors who move quickly can make money. But you must sell the stock before it rebounds.

The next one is the Price/sales ratio or P.S.R.

Use this ratio for new companies with fast growth, but no profits yet. Divide last year`s sales figure by the market value of a firm. Buy if a stock has a low P.S.R. compared to others within its sector ? especially if it`s less than one. For market leaders, the P.S.R. will be around 3 or 4.

The final ratio is the Return on capital employed or R.O.C.E.

This measures management performance. The R.O.C.E. is calculated as profits before tax and interest on loan repayments, divided by capital employed. In sectors like retail, the share price will increase if there is a rising R.O.C.E. A company can improve its R.O.C.E. by buying back shares from the stock market. This can also improve its share price. Buybacks are a definite buy signal for you ? but you have to buy as soon as the buyback is announced to get the maximum financial gain.

  • A stock may appear good value on the basis of one ratio, but poor value on another. Use a number of ratios in analysing a stock and look for consistency before selecting the stock you will invest in.
  • You must always remember though, the stock market is unpredictable because of the market sentiment factor, so there are times when shares drop in value without any warning, you must be prepared for this too. But stick to a successful picking strategy and you could build a safety barrier for your investments.


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