Here at Equity Mates, we’re trying to break down barriers and help everyone get started on their investing journey. A common issue for beginning investors is the confusion caused by all the different investing terminology. So to help we’re introducing a new segment, Pardon the Jargon.
This blog post explains the 5 terms we covered in Episode 20 of the podcast. Make sure you listen to that episode (link here) to hear more detail about these terms and how they are used.
- EBITDA, EBIT and Net Profit
A simple question, how much profit did a company make, doesn’t always have a simple answer. For investors, there are a number of different metrics that measure profitability. Here we want to define the 3 most common:
Net profit – Total revenue minus all expenses
EBIT – Earnings (net profit) before Interest and Taxes
EBITDA – Earnings (net profit) before Interest, Taxes, Depreciation and Amortisation
EBIT and EBITDA are used by investors to get a clearer picture of how the fundamental business is performing. If an investor uses EBITDA they will see how much revenue the business is earning and by only subtracting the costs of production they will see how profitable the underlying business is.
However, it is important to remember that at the end of the day, EBIT and EBITDA are illusionary. They may help investors understand the business better, but companies pay tax and interest and have to depreciate and amortise their assets – so what you as a shareholder are actually left with is the net profit figure.
- Earnings per Share (EPS)
After looking at a company’s profit, you can divide this by the number of shares in the company. This is important, because as a shareholder each share represents an ownership stake in the business and you can see how much profit each share of the business generates.
To calculate – EPS = Net profit (less any preferred stock dividends – don’t worry too much about this step for now) divided by shares outstanding
This piece of jargon is useful as it allows you to compare the share price to the amount of profit that share will earn for you as a part owner of the business.
- Price/Earnings Ratio (P/E Ratio)
P/E ratio is a quick way of checking how much an investor has to pay for one year of a company’s earnings.
To calculate – P/E Ratio = Share price divided by EPS
For example, say Company A has a $10 share price and has EPS of $1. Then the P/E ratio is 10 – and an investor has to pay 10x one year’s earnings to own a share of the company. Alternatively, if Company B has a $10 share price and EPS of $10 then the P/E ratio is 1 – meaning an investor only has to pay one year’s earnings to own a share.
The average P/E ratio is between 15 and 20, but it does differ between industries. For example, the broadly defined ‘Computer and Technology’ sector has an average P/E of about 25.
- Return on Equity (ROE)
ROE is a good measure of how productive a company is with their assets. It measures how much profit a company has made (or what return it has achieved) from their assets (when you think of assets think – manufacturing equipment, stores, trucks etc. as well as cash – basically things a company owns to make their business run).
To calculate – ROE = Net profit divided by shareholder equity (Shareholder equity can be found on a balance sheet, it is just a company’s assets minus liabilities)
ROE is presented as a percentage with an average being around 15% and anything above 20% generally being good. However, it again differs from industry to industry. Think about the amount of assets required to generate every $1 for a mining company compared to a consulting firm. So it is important to compare ROE within industries.
- Debt-to-Equity Ratio
Most companies will use a combination of debt (money borrowed) and equity (money invested and retained earnings) to grow their business and fund operations. The debt-to-equity ratio is a measure of the balance between the two.
To calculate – Debt-to-Equity Ratio = Total liabilities divided by shareholder equity
For example, if Company A has $100 in debt and $200 in shareholder equity then it has a debt-to-equity ratio of 50% or 0.50.
You will sometimes see this ratio expressed as a decimal or a percentage. Either way it means the same thing. Companies that have too much debt may have trouble paying off that debt in the future, so that is something all investors need to watch out for. However, debt in itself isn’t bad. If a company is funding a new venture or acquiring another company that debt may lead to excellent growth in the future.
Those are the first 5 terms we wanted to introduce in our very first Pardon the Jargon. If you have a term you want explained check out our glossary of key investing terms here or let us know via our website, Facebook or Twitter. To make sure you don’t miss the next episode of Equity Mates Investing Podcast subscribe here.