Helpful terms for comparing companies

Explainers

So, you want to invest in individual companies—but how do you choose which ones to invest in?

13 January 2022

6 min read

One large pineapple is held up on a hand on the left, one small pineapple is held up on a hand on the right.

We’ve previously covered how to choose companies to invest in at a high level, but today we’ll get into the nitty-gritty numbers side of things so you can compare companies like a pro.

Don’t panic! This is all fairly straightforward. Once you understand these terms, you’ll have a much more solid understanding for making investment decisions. Let’s get into it. 

Market capitalisation

Market capitalisation (or market cap) is how much ‘the market’ thinks a company is worth, in total. It’s really useful for comparing the size of different companies. You find it by multiplying a company’s share price by its total number of shares. 

The number of shares plays a big role in determining the company’s current market cap. After all, if you had a company with just one share—for $1,000—it would be worth a lot less than a company with 1 million shares that cost $1 each. Market cap can be thought of as a consensus view of what investors who make up the market think a company is worth. But remember, the perceived value of a company is largely based on predictions about what its future looks like—and no investor has a crystal ball. Your view of the value of a company may also differ vastly from the actual market cap value.

Earnings per share

This is exactly what it sounds like. It’s the earnings (which can also be called net profit, net income, or net earnings) a company has made, divided by its total number of shares. This figure tells you how much profit is generated per share of the company. 

Earnings per share is not the be-all-and-end-all indicator of a company’s performance. Some companies will have low (or even negative) earnings per share because they’re looking to create higher earnings per share in the future.

As with everything, look at earnings per share in the context of your wider goals and investment approach. 

Price-to-earnings (P/E) ratio 

Next up is the price-to-earnings (P/E) ratio—it’s the company’s share price divided by its earnings per share. If you’re buying a share, it shows how much you’re paying for each dollar of income. If you’ve already bought a share, it shows how much your share is valued against income received. 

A company may have high earnings per share but a low P/E ratio if the share price is quite high. Again, this is particularly useful for comparing companies because it “smooths out” differences in share prices and total profits.  

Dividend yield

Dividend yield is the percentage of the share price that the company has paid out in dividends in the past year. This is helpful for evaluating the share option, but keep in mind that past dividends don’t necessarily indicate what future dividends will be.

Here’s an example. Say a company’s shares were $1 each and it paid a dividend of 10 cents per share last year—its dividend yield would be 10%. If the shares were $2 each, and it paid a dividend of 10 cents per share, its dividend yield would be 5%.

In this way, dividend yield is kind of similar to the P/E ratio—the dividend yield can go down (even if the dividend doesn’t change) if the share price goes up. The reverse can happen as well. 

With this number, it’s also important to note that what a company did last year may be quite different to what it’ll do in the coming year. A company which paid a dividend one year, may not pay a dividend the next year. Or, they may pay one which is a lot lower (or a lot higher) than the previous year. It’s like the old saying—past performance is no guarantee of future results!

Equity

Companies are basically built out of two main things: assets and liabilities. An asset is something the company owns that has value—like a machine, land, or a brand. A liability is a debt owed by the company—like a bank loan, some existing bonds, or even money promised to employees and suppliers.

A company’s equity is its total assets minus its total liabilities.

A good way to think of this is to compare it to your personal finances. If you had $10,000 in the bank, but had a personal loan of $20,000, your total equity would be negative $10,000. On the other hand, if you had $5,000 in the bank, and no debt at all, your total equity would be $5,000.

It’s the same with companies—some companies may have low equity at the moment because they’re trying to invest towards growing in the future. For example, if they intend to build the business using secured debt with affordable interest rates and/or good terms, this may make their future prospects more attractive. 

Return on equity (ROE)

Equity is essentially the total amount of money a company has invested. When you compare this figure to its earnings, you can find out how much of a return it made from that investment. If a company’s equity is $100m, and it made $10m this year, then its return on equity (ROE) is around 10%.

This is a really useful tool, because you can compare a company’s return on equity to what it could have made by investing elsewhere. Then (you guessed it) you can compare different companies’ return on equity.

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation, and amortisation. This one looks complicated, but it really isn’t. 

Simply put, EBITDA is a way of showing the operations, profitability, and performance of a company. Many investors prefer EBITDA over earnings because it leaves out any costs that aren’t directly tied to these metrics. It’s also used in many commonly cited valuation and profitability ratios—like the EV/EBITDA ratio, or EBITDA margin. 

Earnings on their own are pretty straightforward—they’re the money a company has made, minus its expenses. To get to EBITDA, you also remove interest, tax, depreciation, and amortisation. Let’s break each of these down a bit more.

Interest

Interest is removed because it’s an expense associated with how the company is financed—as in, how much debt it has. This can help investors decide whether or not a company is a risky investment, but it doesn’t show how well a company’s business is performing.

Tax

Tax paid by a business is profit it doesn’t get to keep. Taxes are set by the country where the company operates, and don’t show anything about how profitable the company may or may not be.

Depreciation and amortisation

Depreciation and amortisation are expenses related to a company’s assets, and account for the wear-and-tear costs over their useful lifetime and eventual replacement. 

For example, if you had a company that owned machinery that needed to be replaced every 20 years, you’d see 1/20 of that machinery’s purchase cost as an expense on their annual income statement—this is called depreciation. Amortisation is similar, but applied to non-tangible assets (things you can’t touch). 

The reason why they’re removed for EBITDA is because these costs aren’t directly related to the company’s operational performance.

It’s about the mix

These are just a few terms you might run into when you’re reading up on companies to invest in. The key thing to remember is that none of these indicators gives you a perfect view of a company, and none can immediately tell you if the company is worth investing in. Rather, you need to understand what they’re telling you, compare them against each other, then think about your investing approach, goals, time horizon, and so on.

And remember, there are other ways to choose a company to invest in. Some investors invest without looking at any figures like this at all! For example, people invest in companies they want to see succeed, or companies they enjoy doing business with, or companies whose values are in line with theirs—you can invest based on any criteria you want to suit your needs and personal circumstances.

Ready for more? Here’s another jargon-breaking article.


Ok, now for the legal bit

Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.

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