1. Investors
  2. Manage your investments
  3. Understanding valuation ratios

Understanding valuation ratios

Page last updated: 22 Mar 2019

When you are investing in shares, ratios and multiples can be handy as they can help you work out which ones are good value for money. The main ratios and multiples to consider are:

Dividend yield

If you want an income, looking at dividend yields helps identify companies you may want to invest in. The dividend yield is the dividend a company pays to its shareholders as a percentage of its share price. For example if a company pays a dividend of four cents per share and the current share price is one dollar, its yield is four percent.

In New Zealand you’ll hear about two types of dividend yields:

  • net or cash dividend yield (the amount you receive in cash) and
  • gross dividend yield (includes the value of any imputation credits attached).

If you’re a New Zealand tax resident you should generally pay more attention to the gross dividend yield as the imputation credits attached will reduce any tax due on the dividend. 

Price-earnings ratios

The price-earnings ratio (PE ratio) helps you compare the price of different companies’ shares relative to their earnings (or profit) per share.

Companies commonly express their PE ratio as a multiple of one. For example, when a company has a price-earnings ratio of 10, this means investors are willing to pay 10 dollars for every dollar the company makes. A higher ratio implies investors are paying more per share relative to the company’s earnings, whereas a lower ratio implies investors are paying less per share. 

You need to be careful with this ratio. A lower price earnings ratio doesn’t necessarily mean the share is good value. It could be considered more risky than other companies. It’s important to use this ratio alongside other ratios.

Enterprise value ratios

Similar companies can fund their business in different ways. For example, Company A may be paying high interest after borrowing lots of money, whereas Company B may not have borrowed any money and is paying no interest.

Using enterprise value ratios helps you assess the value of a company independently from how they fund their business.

You can calculate this by taking a measure of operating earnings, such as earnings before interest and tax (EBIT), and comparing it to the value of the business (generally assessed as market capitalisation plus net debt). Like price-to-earnings ratios, this is expressed as a multiple of one. A higher ratio implies investors are paying more for the company’s operating earnings, and a lower ratio implies investors are willing to pay less.

Total return percentage

Some companies pay dividends, some don’t. So, when you’re comparing potential returns from different companies you need to consider capital growth and dividends. This is where the total return percentage is helpful. You can calculate the total return percentage over a period by adding together the expected percentage increase in a company’s share price and its expected dividend yield. 

Some important tips when using ratios

Interpret valuation multiples and ratios carefully.

All companies are different and there could be valid reasons why they have used different ratios. What’s considered a good ratio varies from industry to industry.

Don’t rely only on valuations when making your decision to invest.

Valuations only measure share prices relative to earnings or dividends at a particular point in time. Just because a company recently paid large dividends or made a great profit last year, it doesn’t mean they will continue to. And vice versa, if a company has made poor profits in the past it’s no guarantee they will make poor earnings in the future. In some cases, you may be willing to pay more because you consider the current year’s low profit an anomaly. See Knowing which shares to invest in to learn more.

Be careful when comparing ratios calculated by different people.

A ratio used in the Herald won’t be the same as in a research analyst’s report as they may have used different methods to do their calculations.