A few metrics to guide your investment decisions

The world of finance and investments is full of jargon and metrics that can seem bewildering. Essentially, most metrics serve as a measure of a company’s profitability or earnings potential, and highly trained professionals such as accountants and certified financial analysts (CFAs) do the heavy lifting of crunching the numbers. But you don't have to be a CFA to have a basic grasp of the concepts that will help to inform your investment decisions. Following is a list of some of the main metrics for investors:

EBITDA?

This refers to “earnings before interest, taxes, depreciation, and amortisation”. This is a commonly used measurement of a company’s cash profits. But it is not a completely accurate gauge and is pointedly excluded from the Generally Accepted Accounting Principles (GAAP) guidelines that publicly listed companies in the US must follow when preparing financial statements.

One criticism of EBITDA is that it can overstate profits – a polite way of saying that it can be smoke and mirrors – hence its exclusion from the GAAP.

Some companies will use “EBIT” (earnings before interest and taxes) instead, which, as the name suggests, captures earnings before tax and interest expenses are deducted.

As an example, JSE-listed petrochemicals group Sasol uses both. Sasol’s recent interim results report showed its EBITDA for the six months to the end of December 2022 climbed slightly to R32,268 billion from R31,244 billion in the comparable in 2021. But its EBIT showed a slight decline to R24,204 billion from R24,309 billion.

HEADLINE EARNINGS/HEADLINE EARNINGS PER SHARE (HE/HEPS)?

This is a metric that JSE-listed companies have been required to disclose since 2000, and it is the one that analysts, markets and investors often scrutinise first in financial or results statements.

A circular issued by the South African Institute of Chartered Accountants (SAICA) in 2021 about HE/HEPS, stated that: “One of the main uses of a single earnings number in South Africa is in the calculation of a consistent price earnings (P/E) ratio” (see

below).

Like EBITDA, HE/HEPS are a useful measure of a company’s underlying profit and future earnings potential. This measure is often used in South Africa to calculate a company’s P/E ratio, and is therefore a useful comparison of its performance with its peers.

Getting down to brass tacks, headline earnings strip out once-off or exceptional items such as assets written off or changes in corporate tax and foreign exchange rates, among others. So the metric gets to the heart of the matter, focusing on the core profitability of an enterprise.

PRICE EARNINGS (P/E) RATIO?

A P/E ratio is based on a simple formula: dividing the current stock price by earnings per share (EPS). In South Africa, the EPS is usually HEPS. Companies operating at a loss cannot be measured in this way because there are no earnings to plug into the formula.

A high P/E ratio (for context, the market average P/E ratio currently ranges from 20-25) can be a signal that a company’s share price is overvalued. Alternatively, it can reflect expectations that its future earnings will shoot the lights out.

DIVIDEND YIELD?

A dividend yield is calculated by dividing the dividend – the money a company

gives back to shareholders, generally (or hopefully) from earnings – by its current share price.

A dividend yield higher than a company’s peers shows that it is paying more to its shareholders relative to its stock price. A relatively low yield is not necessarily a sign that a company is not paying a healthy dividend, as a rise in its share price will lower the yield.?

Conversely, a higher yield is a consequence of a declining share price. Companies will sometimes say that they have an “industry-leading” dividend yield but that can be misleading if their share price is tanking.

DIVIDEND RATIO PAYOUT

This is the ratio of a company’s earnings paid to shareholders expressed in

percentage terms. Companies will often have payout policies of, say, 25% to 35% of earnings. Sometimes that will be raised when a company’s annual earnings rise significantly, or if it has made extra cash through a once-off windfall.?

JSE-listed Gold Fields did that recently when it received a $202-million “break fee” from a takeover target after the deal fell through. Regular dividends provide a regular cash flow to investors for holding shares in a company. But even profitable companies can withhold dividends, especially interim dividends, for a range of sensible

reasons. These include paying down debt or using the proceeds for investment purposes aimed at generating future earnings.

Some helpful tips for reading financial statements

• Headline earnings are the main profit metric in South Africa but others are also used in the same financial statements. For example, alternatives to headline earnings can be used to calculate the dividend ratio payout. These include “normalised earnings” or “adjusted earnings”.
• In a financial statement, companies will usually use a variant on an asterisk (*) next to a term directing you to read the definition below.
• Stock exchanges, regulatory bodies and professional accounting associations have stringent rules and standards for the preparation of financial statements. This does not mean that the books cannot be cooked as thoroughly as a Sunday braai when the chef has had too much red wine. The Steinhoff and Tongaat Hulett scandals stand as warnings to investors: buyer, beware. Having said that, they are exceptions, not the rule, and reported earnings are generally a transparent take on a company’s profitability and performance potential.