How do you work out if a company is worth investing in? Fund managers reveal their ‘magic numbers’

The secret to successful investing is surely just identifying the best companies that show the most potential, right? If only. 

Paying a good price is equally as important – after all, there’s often no point in buying a top company if it’s so expensive that its share price will never rise.

However, working out the value of a company is not straightforward. You could base it on how the price compares to similar companies, if its value is likely to rise or what it is likely to pay out to shareholders as dividends, for example.

We asked fund managers for the rules of thumb or formulae they apply to companies to assess whether they’re worth investing in – or best avoided.

Here, Wealth investigates some of their most popular ‘magic numbers’ and how you can use them to decide where to put your money.

Clever tricks: Wealth investigates some fund managers’ most popular ‘magic numbers’ and how you can use them to decide where to put your money

Price to earnings ratio 

What it is: This shows how much a company is valued by the stock market compared to how much it is earning its shareholders.

How you calculate it: Divide the share price by a company’s earnings per share for the full year, which are available on their published financial statements. The price to earnings ratio – also known as the p/e ratio – is expressed as a multiple. So you might say a company is on ‘five times earnings’ or ‘100 times earnings’.

Published financial statements only reveal what a company has achieved in the recent past. Some investors choose to do the same calculation with estimated earnings for the current year. This will give what is called a ‘forward price earnings ratio’. However, as these numbers are only predictions, there is no guarantee that they will prove correct.

Why it matters: Fund manager Eric Burns, who runs the Sanford DeLand Free Spirit Fund, says the price to earnings ratio provides a ‘ready reckoner’ to show how cheap or expensive a share is relative to other, similar ones in the same sector. On the face of it, a share with a p/e ratio of three looks much cheaper than one with a p/e ratio of ten.

You can also use it to see whether a share is cheaper or more expensive than it has been historically compared with its profits by seeing how a price to earnings ratio changes over time.

But beware: Valuations like this are a shorthand, says Jamie Mills O’Brien, investment director at financial group Abrdn. However, they have limitations.

The price to earnings ratio shows how much a company is valued by the stock market compared to how much it is earning its shareholders

Price to earnings ratios do not show how a company is growing or whether it has special characteristics that should enable it to grow over long periods.

For example, investors looking at Novo Nordisk, which makes weight-loss drug Ozempic, may have rejected the company in the 2000s as too expensive based on its high price to earnings ratio. However, it has continued to see such growth due to the patents that it holds that it still would have made a good investment.

‘The reality is an investor could have paid a price to earnings multiple of over 100 for Novo Nordisk in 2005 and still come out with a double-digit percentage annualised return,’ says Mills O’Brien.

Burns warns against buying companies that are simply cheap, without doing more homework.

‘There is no point buying a company trading on a price to earnings ratio of two, for example, if it’s indebted to the eyeballs and not going to be around in a year’s time,’ he says. ‘Don’t conflate cheap with good value.’

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Price to sales ratio 

What it is: A similar way of valuing a company to the price to earnings ratio also expressed as a multiple, but it uses sales rather than earnings figures.

How you calculate it: Divide a company’s market capitalisation, which is the number of shares multiplied by the price per share, by its total sales over the past 12 months.

Why it matters: Like the price to earnings ratio, it shows how much a company is valued by the stock market compared to its performance, but some fund managers say it is more accurate to consider sales rather than past earnings when predicting future performance. 

‘You can’t lie about sales,’ says fund manager Richard de Lisle who runs the De Lisle America Fund.

He says that, traditionally, a good level to buy was if the price to sales ratio was below 0.7 – in other words the sales were at least 1.5 times the market capitalisation of the company.

But beware: De Lisle says the performance of new technology companies in recent years has changed the game and the price to sales ratio isn’t always a good predictor of future growth.

Companies such as Microsoft, Facebook owner Meta and Google’s parent company Alphabet have high price to sales ratios, but they have copyright that mean they could enjoy solid sales for years.

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Dividend yield 

What it is: Companies often return some of their profits to investors in the form of a regular cash payout – or dividend – per share a number of times per year.

The dividend yield of a share is expressed as a percentage and represents the amount of money a company pays out in dividends compared with its share price.

How you calculate it: Find the dividend paid out per share for the full year for a company (you can find this in its financial statements) and then divide it by the share price. Alternatively, you could use an estimate of future dividend payments – analysts produce these forecasts – to work out a forward dividend yield.

However, there is no guarantee it will prove accurate.

Companies often return some of their profits to investors in the form of a regular cash payout – or dividend – per share a number of times per year

Why it matters: The dividend yield shows how much you are getting back for every year that you hold a share. A healthy dividend yield can also indicate that a company is doing sufficiently well financially that it can turn a profit and reward its investors.

But beware: Companies can stop paying out dividends abruptly.

Paying lots of dividends is not always a sign that a company will rise in value too. De Lisle warns that often good yields are a sign that companies cannot do much else with their money to make more profit for shareholders. ‘Sometimes good yields come in boring industries where there might not be much growth,’ he says.

PEG (price/earnings to growth) ratio

What it is: The PEG ratio attempts to factor the growth potential of a business into the equation, and not just current earnings.

How you calculate it: Take the price to earnings ratio as calculated above and divide it by the rate of growth in earnings per share.

In most cases you should use the expected rate of growth between the last published earnings per share figure and the estimate for next year, although some people use historic figures or even five-year estimates.

Why it matters: Fast-growing companies usually have higher price to earnings ratios than those that are growing more slowly, but this can make them look unfairly expensive.

However, adding their growth rates into the mix may give a fairer comparison.

Sam North, an analyst at investment platform eToro, says that the measure allows you to factor in potential.

‘As a general rule, a PEG ratio of 1.0 or lower suggests a stock is fairly priced or even undervalued. A PEG ratio above 1.0 suggests a stock is overvalued,’ he says.

But beware: Analysts may use many different figures to calculate a PEG ratio, and estimates are not always correct.

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