Understanding the fundamentals

When first starting out with investing, it can feel like a whole new world with many confusing acronyms and a lot of data. It can be a job in itself trying to understand the different information, what is relevant and what isn’t. Here you can get a breakdown and examples to help you understand.

Price-to-Earnings Ratio (P/E)

P/E Ratio stands for a price-to-earnings ratio and is the proportion of a company’s share price to the earnings per share. The P/E ratio is the most common form of viewing a stock’s relative valuation.

A company’s P/E ratio can also be benchmarked against other stocks within the same industry or sector to get an idea of whether they are trading in line with the rest of the industry.

The formula for a P/E ratio is to divide the market value per share by the earnings per share.

The P/E ratio is a good fundamental to use as a quick view of whether a stock is under or over valued but further due diligence is required to make an informed decision. View a P/E ratio as a snap shot.

What is a forward price-to-earnings?

This formula uses future guidance rather than trailing figures and is sometimes called estimated price to earnings, as it uses a forward looking indicator.

What is a trailing price-to-earnings?

Much like the forward price-to-earnings, the trailing P/E uses the past performance by dividing the current share price by the total EPS of the previous 12 months.

Example of calculating a P/E ratio.

Using PepsiCo ($PEP) as the example has a share price of $150.63. The Forward EPS of PepsiCo in 2025 is between $8.25 and $8.71 and the trailing EPS is $6.78.

● Calculating forward P/E ratio = $150.63 / $8.48 = 17.76

● Calculating trailing P/E Ratio = $150.63 / $6.78 = 22.21

PepsiCo has a historical 10-year P/E ratio of 25.58 and the average P/E ratio for the soft drink and non-alcoholic industry was 20.71.

EPS stands for Earnings Per Share and is a commonly used measure of a company’s profitability. It measures how much profit each common stock has earned. The higher the EPS the more profitable a company should be considered.

Earnings Per Share (EPS) is calculated by the net income divided by available shares.

Net income ( – preferred dividends) divided by common shares outstanding.

The Earnings in the P/E ratio refers to the EPS.

Using the EPS of a stock, it may look cheap, fair valued, or expensive, depending on whether you look at the historical earnings or estimated future earnings of the company.

How to use EPS?

Earnings Per Share shows an investor how to pick a stock based on profitability, along with other fundamentals, to create a complete picture.

In absolute terms, EPS on its own does not have much meaning, but it is best to compare the EPS to the share price of the stock to determine the value of earnings and gauge the future growth of a company.

What is rolling EPS?

Rolling EPS gives an annual Earnings Per Share (EPS) estimate by combining the EPS of the previous 2 quarters with the estimated EPS of the next two quarters.

Example of EPS.

Company XYZ
Net income: £7.6B
Preferred Dividends: $0.
Common Shares: 3.98B
Basic EPS = £7.6/3.98 = $1.91

Price/Earnings-to-Growth Ratio (PEG)

PEG Ratio stands for price-to-earnings-to-growth ratio. This fundamental is used to determine a stock’s value while also factoring in the company’s expected earnings growth, providing a more complete picture than the more standard P/E ratio.

The PEG ratio can be used as an indicator of whether a stock is over or under prices, but varies by industry and company type.

What is considered under and over valued using the PEG ratio?

The famous investor Peter Lynch says that a company’s P/E and expected growth should be equal. He notes that a fair-value company supports a PEG ratio of 1. When a company’s PEG exceeds 1, then it is considered overvalued whereas a company with a PEG ratio less than 1 is considered undervalued.

How to calculate a PEG ratio?

Using a made-up example we have company XYZ.

Company XYZ:
● Price per share = £46
● EPS this year = £2.09
● EPS last year = £1.74

Given this information we can calculate the PEG ratio.

Company XYZ
● P/E ratio = £46 / £2.09 = 22
● Earnings growth rate = (£2.09 / £1.75) – 1 = 20%
● PEG Ratio = 22/20 = 1.1

What does a negative PEG ratio mean?

A negative PEG can be a result of either negative earnings or a negative estimated growth rate. Both of these can suggest a company may be in trouble.

Dividend Yield

Dividend Yield is a ratio that shows how much a company pays out in each dividend in a yearly context to its stock price.

Mature companies are the most likely to pay dividends, with companies within the utility and consumer staple industry often having higher dividend yields, compared to the tech industry which pay little to no dividends.

Calculating a dividend yield is done by dividing the annual dividend per share by the price per share.

Being cautious of high yielding stocks

Dividend investors are always attracted to high-yielding stocks, but these typically have higher risks than lower-yielding stocks.

High yields don’t always indicate an attractive investment because the dividend yield of a stock may be elevated due to a declining stock price.

A high dividend yield may also indicate a more complex investment such as a Business Development Company (BDC) or a highly complex Collateralised Loan Obligation (CLO) investment fund.

Advantages of dividend yields

According to analysts at Hartford Fund, 69% of the total returns from the S&P500 came from dividends.

A company’s ability to consistently pay and increase dividends is often a strong indicator of its financial health and stability of a company.

Dividends can boost shareholders’ confidence in the management of the company, knowing the company is growing and rewarding the shareholders with a piece of the pie.

Disadvantages of dividend yields

A high dividend yield can be attractive to new or unknowing investors. High dividend yields can come at the expense of the potential growth of the company.

If a company runs into trouble then there is a chance that the dividend gets reduced or becomes eliminated completely.

A stock which share price is trending down can elevate the dividend yield and making it more attractive to a dividend investor, but with added risk of capital loss.

Payout Ratio

Payout Ratio refers to the total amount of dividends that a company pays to shareholders, relative to the net income of the company. The ratio is displayed as a % of the net income. The amount not paid to its shareholders is retained within the company to pay off debts or to reinvest into company segments.

The payout ratio is also referred to as the dividend payout ratio. The amount that isn’t paid as dividends is called the retention ratio.

The payout ratio can be calculated by dividing the dividend paid by the net income of the company or the yearly dividend per share divided by the Earnings Per Share (EPS).

The Retention ratio can be calculated by the Earnings Per Share, minus the Dividends Per Share (DPS) divided by the Earnings Per Share (EPS).

Why is the payout ratio important?

The payout ratio is a financial metric used to determine the stability of a company’s dividend.

A low payout ratio typically means that much of the company’s income is being reinvested back into the company for more growth.

A payout ratio around the 60-70% mark typically signals a mature company which pays out a majority of its income to investors.

A ratio greater than 70% can signal multiple things, including possible trouble (possible cut in the future), an asset class that pays a large amount of its income to shareholders (MLPs) or poor recent financials.

A payout ratio greater than 100% for a normal company is a red flag and should be avoided. However there are companies with structures which require a different calculation to the payout ratio due to the structuring.

What is the difference between a payout ratio and dividend yield?

The payout ratio refers to the percentage of the income the company generated that is paid out, where the dividend yield is how much is returned to the investor via dividends compared to the share price of the stock.

Beta Ratio

The Beta ratio is a measure of a stocks volatility in relation to the overall market, the market typically refers to the S&P500.

The market has a Beta of 1.0 as a standard and stocks are ranked according to how much they deviate from the market.

A stock with a Beta above 1.0 suggests a stock is more volatile than the market it is tracking, whereas a Beta below 1.0 indicates that the stock has smaller volatility.

Beta values and what do they mean?

We have established that the market’s Beta is 1.0 and the Beta of a stock shows whether a stocks trading price fluctuates higher or lower than the market. Here is a visual of different Betas.

Beta	Meaning
1.0	The stock moves inline with the indexed market.
2.0	The stock moves twice as much as the indexed market.
0.0	The stock does not correlate with the indexed market.
-1.0	The stock moves in the opposite direction of the indexed market.

What is better, a high or low Beta?

A stock with a high Beta potentially has a higher reward but carries much more risk than a stock with a lower Beta. The opposite is true with a stock that has a low Beta, where it poses less risk but also offers lower potential rewards.

In reality, it depends on you as the investor, whether you can stomach higher swings in a stocks price. There is no right or wrong, a Beta can be taken in different ways depending on how you want your portfolio to act.

What does a Beta indicate?

It is important for investors to make the distinction between short-term and long-term risks. A Beta is a good indication for short-term market moves, and so is more important if you are trading as you rely upon the gaps between the top and bottom prices. Where long-term investing looks at the fundamental risks, rather than the short-term volatility of a price.

A stock with a high Beta may mean high price volatility in the short term but does not always rule out long-term opportunities.