What market data does and does not tell you

The distinction that matters: facts and estimates

Market data divides into two categories, and confusing them is the source of most misunderstanding.

Reported facts come from a company's lodged financial statements: last year's revenue, the cash balance at balance date, the number of shares on issue. These are audited, dated, and traceable to a document you can obtain. They are still subject to judgement — accounting involves estimation — but the judgement was made and disclosed by the company, under standards, and an auditor has examined it.

Estimates and derived figures are everything else. A forecast of next year's earnings is an estimate. A price-to-earnings ratio calculated on forecast earnings is an estimate wearing the clothes of a fact. A price target is one person's estimate, restated as a number. None of this is illegitimate — markets could not function without forward-looking analysis — but an estimate presented without its basis is not evidence, and treating it as though it were is how reasonable people end up surprised.

A practical habit: whenever you see a number about a company, ask which of the two it is, and what period it refers to. The question takes seconds and eliminates a large share of the ways market data misleads.

The price-to-earnings ratio

The price-to-earnings ratio divides a company's share price by its earnings per share. It is the most quoted valuation measure in existence and the most frequently misunderstood, for one reason: the word "earnings" in the denominator can mean several different things.

Three further points explain most of the confusion around this ratio.

• It is not a measure of value on its own. A low ratio relative to similar companies does not mean a company is undervalued. It can mean the market expects earnings to fall, that earnings included a one-off gain, that the business carries risks the comparison ignores, or that the sector is out of favour. The ratio is a question, not an answer.
• Comparisons only work within similar businesses. Comparing the ratio of a bank with that of a software company tells you almost nothing, because the two have different capital structures, revenue recognition and growth profiles. Like-for-like comparison requires like-for-like businesses.
• A negative or meaningless denominator breaks it. A company reporting a loss has no meaningful PE ratio, and data providers handle this inconsistently — some show nothing, some show a negative figure, some substitute a different earnings measure without saying so. A displayed PE can therefore be calculated on a basis you would not have chosen.

Dividend yield

Dividend yield divides annual dividends per share by the share price. Its apparent simplicity hides a mechanical relationship that catches people out: because the price is the denominator, the yield rises when the price falls. A rising yield is at least as likely to reflect a falling share price as it is to reflect a company increasing its dividend.

This matters because a high yield is often read as a signal of attractiveness, when it is frequently the market's assessment that the dividend is at risk. The relevant question is not what the yield is, but whether the dividend is covered by the cash the business generates.

To assess coverage, compare cash dividends paid against operating cash flow, not against statutory profit. Both figures come from the financial statements, and the comparison is arithmetic rather than opinion. A company paying out less in dividends than it generates in operating cash flow is funding the distribution from trading. A company regularly paying out more than it generates, and making up the difference with borrowings or asset sales, is doing something different — which may be a deliberate, disclosed decision, and is worth understanding before treating the yield as income.

Two further cautions. First, a trailing yield uses the past twelve months of dividends; where a company has cut, suspended or paid a special dividend, it will not describe the year ahead. Second, franking credits change the after-tax value of an Australian dividend in a way that the headline yield does not capture, and the benefit depends entirely on your own tax position — a matter for a registered tax agent, not a market data page.

Book value, price-to-book and debt ratios

Book value is assets minus liabilities: what the accounting records say the owners' stake is worth. It is a reported figure, and for some businesses it is a meaningful reference point. For others it is close to meaningless — a services business whose main assets are its people will show very little book value, because accounting rules generally do not permit a company to record its own workforce as an asset.

Price-to-book compares the share price against book value per share. A ratio below one is sometimes described as trading below the value of the assets. That description is only as good as the book values themselves: intangible assets such as goodwill may be carried at amounts that depend on the assumptions in an impairment test, and inventory may be carried at cost when its realisable value has fallen. The note on impairment testing is where you find the assumptions; it is worth reading before drawing conclusions from the ratio.

Debt ratios — debt to equity, net debt to earnings, interest cover — are only comparable when calculated the same way, and in practice providers differ on what counts as debt. Lease liabilities, hybrid securities, provisions and off-balance-sheet commitments are treated inconsistently. The reliable approach is to read the borrowings note and the maturity table in the financial statements and form your own view of what falls due and when, rather than relying on a single displayed ratio whose construction is not shown.

Broker notes, ratings and price targets

Broker research is professional analysis, and it is worth understanding what it is and what it is not.

A price target is one analyst's estimate of where a share price will be at a future date, based on assumptions about earnings, growth and the multiple the market will apply. It is an estimate, it is dated, and it is frequently revised. It is not a prediction with a track record of accuracy, and a target above the current price is not a statement that the price will rise — it is a statement about the analyst's assumptions.

Ratings are typically relative rather than absolute. A "buy" rating from a firm's research department usually means the analyst expects the stock to outperform that firm's coverage universe or a benchmark over a stated period. It does not mean the analyst believes the investment is suitable for you, and analysts generally do not know your circumstances.

Readers should also be aware of structural considerations that are disclosed but easy to overlook. Research departments sit inside firms that may earn fees from the companies covered, from underwriting, advisory work or trading. Firms publish policies on how research and commercial activity are separated, and disclosure statements appear on the research itself. Reading those disclosures takes a minute and tells you what incentives sit around the note you are reading.

The useful part of broker research is rarely the recommendation. It is the underlying work: the assumptions made explicit, the industry data assembled, the questions the analyst thought worth asking of management. Those you can evaluate on their merits. The rating is the least informative line in the document.

What a price chart does not show

A price chart is a record of transactions that have already occurred. It shows where buyers and sellers agreed on a price in the past. It contains no information about the future, and the shapes people perceive in it — trends, support levels, patterns — are interpretations rather than established relationships.

One mechanical point is worth knowing because it distorts comparisons between companies. A chart of price alone ignores dividends. A company that pays out a substantial portion of its returns as dividends will show a flatter price line than a company that retains everything, even if total returns to owners were similar. Charts of total return, which assume dividends are reinvested, address this; unadjusted price charts do not. When comparing two companies' long-run performance, check which basis the chart uses.

A short checklist before quoting any number

1. Is this a reported figure or an estimate? If it is an estimate, whose, made when, and on what assumptions?
2. What period does it cover? A reported figure from eighteen months ago describes a business that has since changed.
3. What is in the denominator? Not all earnings are the same earnings, and not all debt is counted the same way.
4. Is the comparison like-for-like? Ratios only mean something against genuinely similar businesses, over the same period.
5. Who benefits if I read it this way? Not a reason to dismiss a figure, but a reason to check the primary source, which is usually free to obtain.

What this guide does not do

It does not say which measures are the right ones to use, and it does not tell you whether any company is good value. Measures are tools, and which tool suits a question depends on the question. What the guide does argue is narrower and, we think, more useful: that knowing what a number is made of, and whether it is a fact or an estimate, is the precondition for using it at all.