Investment terms and metrics to learn
If you’ve only got a minute:
- Understanding investment terms and metrics can be daunting at first but are necessary in our investment journey.
- An investment portfolio is built through using capital to purchase assets, which are then held in varying proportions in line with our investment objectives.
- Financial ratios are used to evaluate the overall financial health of a company.
As a first-time investor, making sense of investment jargon and investment metrics can be a daunting task. This is especially true if you have little to no experience in understanding financial concepts.
Studies have shown that people have avoided investing altogether due to the perceived difficulty of getting around to understanding these terms. Still, the fact remains that investing presents opportunities to make your money work harder, so do not feel intimidated by them. They can be explained simply and the more familiar you are with them, the less you will shun them.
Here are common investment terms and metrics used to evaluate stocks that you may encounter when having to make investment decisions.
Common investment terms
Learning some common investment terms will help you to gain confidence in making informed decisions.
This term is often used to describe the objectives, guidelines and rules that investment managers abide by for a specific portfolio or pooled fund. Simply put, a mandate governs how an investment manager should invest money for clients. They are broadly defined and depend on investment objectives.
For a fund with a capital preservation mandate, the investment manager of the portfolio will focus on minimising volatility, even if it means accepting lower returns. Likewise, an investment mandate tailored to capturing growth opportunities in tech companies might be riskier but could result in higher returns.
As an investor, you must know the objective of that fund and what it is investing in.
In investing, asset allocation is a strategy that considers your individual risk tolerance. Once you have assessed your risk profile, your capital (the amount of savings set aside for investment) is then divided across different asset classes like stocks, bonds, real estate, cash and commodities.
Bear in mind that each asset class has different levels of return and risk, and performance varies depending on the economic climate. In general, more risk averse investors may decide to allocate more capital to bonds and cash over equities. The reverse may hold for those who have a higher risk tolerance.
An investment portfolio consists of a group of assets like stocks, bonds, real estate, cash and commodities held in varying proportions. Through a combination of these assets – asset allocation – investors aim to achieve a return in line with their risk tolerance and financial goals.
An optimal investment portfolio is one that delivers the maximum performance for the individual’s risk tolerance. Investment portfolios usually consist of an allocation of funds along different asset classes (i.e. bonds, stocks). Within the asset classes, funds can be further divided by geography or sector (i.e. Asia ex-Japan or Technology).
When you hear investment strategists saying they are overweight or underweight in a particular market, what they mean is that on a shorter-term basis, there is a preference for one market or asset class over another.
For example, in a balanced portfolio, the optimal weight for the long-term is 50% equities, and 50% in bonds. In the case of a balanced portfolio, both equities and bonds are said to be equal weight or neutral. If investors expect the economy to do well and equities are favoured, you will want to be overweight equities. As such, equities could take a 55% weighting in your portfolio, while bonds are underweight at 45% of the portfolio.
Market capitalisation or market cap refers to the total value of a company based on the value of all its shares at the current share price. If the shares of a company are trading at $1.50 and the total number of outstanding shares is 6 billion, the company has a market capitalisation of $9 billion (i.e. $1.50 x 6 billion shares). Do note that market capitalisation fluctuates regularly as share prices change multiple times a day.
By using this measure, you can compare the value of the company against others. Market capitalisation also serves as a reflection of what investors believe a company’s value is.
Net asset value (NAV)
NAV represents the net value of an entity. It is calculated by subtracting the total value of liabilities from the total value of an entity’s assets. Similar to how share prices are an indicator of how much a company is worth, NAV serves as a measure of how a unit in a unit trust or exchange-traded fund (ETF) is worth.
You may also find NAV useful when comparing which unit trusts or ETFs with similar investment mandates to invest in.
Common investment metrics and financial ratios
Understanding these metrics and ratios can help you to analyse a company's fundamentals better.
A popular metric for dividend stocks and Real Estate Investment Trusts, dividend yield is a measure of a company’s dividend per share divided by its share price, expressed as a percentage. Dividend yield serves as an indicator of a return on a stock based only on its dividend. If dividend stays constant, then the yield will rise if stock prices fall.
While a higher yield might appear attractive, do take note that the measure is often calculated based on historical dividends. This means that if share prices have declined sharply over a short period of time, dividend yields will be elevated. However, it does not make it an attractive investment, especially if the company is anticipating weak financial performance.
Dividend yielding products are an attractive option for retirees. Investing in less volatile, high dividend products is one way to supplement lost income due to retirement. If you prefer to receive regular payouts, this is an option for you too.
For those who prefer to grow their investments, they can choose to reinvest their dividends.
Compound annual growth rate (CAGR)
CAGR is used to measure an investment’s growth rate over time, in particular, the annual growth of your investments, assuming that profits of the company were reinvested at the end of each period.
It can be used to compare the performance of different investments against each other, or against a benchmark.
CAGR = (Ending balance/beginning balance)1/n – 1, where “ending balance” is the value of the investment at the end of the period, “beginning balance” is the value of the investment at the beginning of the period, and “n” is the number of years you have invested.
Investors tend to prefer using CAGR as it smooths out the volatile nature of year-by-year growth rates.
Price-to-earnings (P/E) ratio
One of the common ways to value a company is by using the P/E ratio. This financial ratio measures a company’s stock price relative to its earnings and is one of the most common ways to evaluate if a company is over or undervalued before making an investment decision.
Simply put, the P/E ratio is the price investors are willing to pay for $1 of a company’s profit. It is calculated by taking the current share price divided by earnings per share (EPS).
The P/E ratio can be measured as a trailing (it takes into account recent EPS) or forward (based on forecasted EPS) ratio.
For example, if Stock Z is trading at $10 and EPS for the most recent 12-month period is $0.50, then the P/E ratio of Stock Z is 20. If we assume profits stay constant, it will take the investor 20 years to regain its share price. Put another way, the investor is investing $20 for every dollar of annual earnings.
Investors should note that the PE ratio does not in itself indicate whether the share is a bargain. The P/E ratio depends on the market’s perception of the risk and future growth in earnings and can differ from sector to sector. This should be evaluated in conjunction with other financial ratios.
Price-to-earnings-to-growth (PEG) ratio
The PEG ratio is an enhancement on the P/E ratio which takes into account the earnings growth of a company. It is calculated by dividing the P/E ratio by the growth rate of a company’s earnings over a specified period. This allows investors to account for past earnings while providing a gauge for future earnings.
Generally, if the PEG ratio is more than 1.0, a stock is said to be overvalued while a value of less than 1.0 suggests a company could be undervalued.
Earnings before interest, tax, depreciation and amortisation (EV/EBITDA) ratio
The enterprise value to earnings before interest, tax, depreciation and amortisation ratio (EV/EBITDA) ratio is another measure used to determine the value of a company. It is calculated by taking the market capitalisation of a company plus debt minus cash.
EV/EBITDA is usually used in tandem with the P/E ratio to valuate a company. A low EV/EBITDA value might point to a stock being undervalued while a high EV/EBITDA could suggest a stock is overvalued.
That said, one should take note that EV/EBITDA tends to be larger for high growth sectors or companies while they are lower for those operating in stable growth sectors.
Price-to-book (P/B) ratio
The P/B ratio, which measures the market value of a company relative to its book value, is another commonly used metric for evaluating stocks. It is calculated by dividing a company's price per share by its book value per share.
Theoretically, if a stock has a P/B ratio of 1.0, it is “fairly valued”. In other words, when all assets in a company are liquidated and debts are paid, the price of the stock will be same as its book value.
The P/B ratio is handy when used for companies with high tangible assets (physical assets) but is not as reliable in evaluating companies with more intangible assets like technology firms.
Return on equity (ROE)
A profitability measure, ROE shows how effectively a company utilises its assets to generate profits. Expressed as a percentage, it is calculated by dividing net income by shareholders' equity. The higher the ROE, the better.
In general, you should compare ROE of companies within the same sector. If a company has a better ROE than the average of its peers, it would be safe to say its management is better than most others at using assets to generate profits.
ROE is often used with the P/B ratio. A stock is said to be overvalued when ROE is low but the P/B ratio is high. The reverse holds for an undervalued stock.
Debt-to-equity (D/E) ratio
The D/E ratio shows how much debt versus how much of its own funds a company uses to finance its operations. It is calculated by dividing a company’s total liabilities by total shareholder equity. The lower the figure, the better. That said, like other financial ratios, it should not be looked at in isolation.
Higher debt levels are not necessarily a bad thing, especially if the company is able to produce returns higher than the interest charged for its debts. A company with a lower D/E ratio than its peers has more avenue to raise funds for expansion through borrowing.
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Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.
All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.
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