How to research stocks with financial ratios?
Using ratios can appear to be easy; unfortunately you cannot use only one ratio as they all have some drawbacks.The good news is that article will help you to understand various ratios and how to use them in the most efficient way.
A lot of ratios are available; some of them measure the capitalization level of a company when others show the profitability of a firm.
How to use these ratios?
You can compare them against a sector, an industry or another company (in practice it is very difficult to find firms that share the same risk, growth and characteristics).
You can compare these ratios against the company it self and see if over the years, the company position has improved or not.
» Intrinsic value
You can use rules of thumb but it is the less efficient way to use financial ratios but it helps to understand them.
These ratios are used to understand if a firm is not over-leveraged. The short-term debt can be sustainable in the short run but maybe it is not the case in the long run.
To control is a company is correctly capitalized, the use of the following ratios are helpful:
Debt to asset ratio:
Total Debt /Total assets
A ratio under 1 means that at least of half of assets is financed with equity.
Long-term debt to equity ratio:
Long-term debt/Shareholder equity
This ratio excludes the short-term liabilities. For example a company can roll over continuously its short-term commitment. In this case it is more long term financing.
To solve this problem, you can still use the total debt to equity ratio.
Total debt to equity ratio:
(Current liabilities + Long-term debt)/Shareholder equity
Time interest Earned ratio:
Operating income (EBIT) / Annual interest payment
The interest coverage ratio checks if the revenues before taxes and interests are enough to pay at least the interests charge.
Current assets/ Current liabilities
The current ratio is helpful when determining the short-term risk of a company.
(Current assets-inventory)/current liabilities
A drawback of the current ratio is that it includes company inventory. In some industries, inventories can become rapidly obsolete (like in the hardware industry). The quick ratio solves this problem by taking out the inventories.
Cash + marketable securities/Current liabilities
This is the most conservative ratio because it takes in account only the most liquid assets against the current liabilities. Are these liquid assets are sufficient to cover the current liabilities?
Net receivable sales/Average net receivable
This ratio calculates how many times the account receivables have been collected during an accounting period. A low ratio could indicate some collection problems (like bad client credit).
Average collection period:
(Average net receivable/ Credit sales)*365
It is the number of days it takes to a company to convert its receivable into cash.
A low ratio can be problematic because for some industries, inventories can become obsolete (computer hardware industry).
Fixed asset turnover:
Net sales/Average fixed assets
A low turnover means too much assets for few sales.A high turnover means a lack of productive capacity to meet sales demand.
Total asset turnover:
Indicates the effectiveness of the firm’s use of its total asset base. For example it range about 1 for large capital-intensive industries (like steel, auto).
Profitability ratios measure how the firm is able to generate profits.
Gross profit margin:
Revenue-COGS /Revenue or Gross profit/sales
The gross profit margin shows the basic cost structure of the firm. Thanks to this ratio, you can check if the basic business is viable or not.
Return on assets:
Net earnings/Total assets
Total asset turnover cousin but on net earning.
Operating profit margin (Return on sales):
Measures how much profit is generated per sale.
(Sales-cost of good sold-operating expenses)/sales
Return on equity (ROE):
Net earnings/owner’s equity
ROE measures the profits for each dollar invested.
To understand how a ROE is composed, you can compute a DuPont analysis:
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier)
(Net profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)
As you can see form this model, a company has three ways to have a high ROE:
» The company has great profit margin. For example the luxury industry has high profit margin, because for example a Gucci handbag is sold several time its cost.
» The company has great asset turnover. It is the case in the retails industry. For example, Wal-Mart is able to sell a lot of things and make profits thanks to the economy of scale.
» The company has leveraged its balance sheet (the company has a lot of debt financing).
Return on invested capital (ROIC):
Net operating profit after taxes/(owner’s equity + long-term debt)
EBIT less taxes/asset- excess cash- non-interest liabilities
Where excess cash is the cash sitting on the company accounts but that it is not required for operating purposes.
Non-interest liabilities: it is generally the account payables; it is sort of an investment made by the suppliers.
Dividend policy ratios
Dividend per share/ Earning per share
With the payout ratio, you can see how much a company is distributing from its earnings.
Dividend per share/Stock price
It will help you to compare the relative attractiveness between various dividend-paying stocks.
Price earning ratio (PE):
Stock price/Net earnings per share
Price to earning ratio is the most used ratio in investments.
As a rule of thumb, a PE over 20 is considered expensive and a PE less than 10 is considered cheap.
Note: Various things can impact earnings: dilution of earnings because of options. The best way (but a bit more complicated):
(Market capitalization+ value of options)/(net income+ option expense)
Another problem with using the PE, it excludes companies with negative earnings.
Finally when comparing PE against past history, you must always look at the risk free rate at the same time. Why? Because, if interest rates are higher, price earning ratios also will be higher.
To incorporate the earning growth and make PE more comparable across companies, PEG is the solution. The PEG ratio measures the relative trade-off between stock price, earning per share and company growth.
Price earning to growth ratio (PEG):
Price earning ratio /Earning growth
As rule of thumb: The lower, the better. The problem with PEG ratio is that you don’t account for risk.
Price to sales:
The lower this ratio is, the better. This ratio is useful when comparing companies with the same operating structure or if the company is new and is not yet making money.
You can also use the enterprise value to sales:
Enterprise value/sales where enterprise value: market value of equity + market value of debt-cash
Price to book:
Stock price/Book value per share
Price to book is commonly used when comparing financial institutions.
Enterprise value: market value of equity + market value of debt-cash.
EBITDA: earning before interest, Taxes and depreciation.
You should pay particular attention if you have any minority interest. As a rule of thumb, company’s ratio less than 3 is considered cheap.
Note: Corporations in countries with high taxes will always appear cheaper using the EV/EBITDA.
Which valuation ratio to use?
Housing value/rental income: market price of house/annual rental income
When this ratio is high, the market is considered overvalued, when the ratio is low it is considered cheap.
You usually use the P/E or relative P/E, often with normalized earnings.
For growth firms, you use the PEG ratio because it incorporates the most important input: Growth! (Note: growth rates can be very different).
Young growth firms with net losses:
For young firms, you have no choices but to use revenue multiples like return on sales.
EV/EBITDA, you have generally big depreciations and net loss at the beginning.
Stock price/(EPS + Depreciation per share)
Usually you have big depreciation charges on real estate.
Price/book equity, banks tend to mark to market their portfolios.
For retailing, you can use revenue multiples like price to sales. You can improve your margins but they will equalize sooner or later.
Limitations of ratios
When selecting a stock for investing, ratio valuation is not sufficient.For example, if you are looking for a cheap stock using the price-earning ratio, you must also look at the following items:
» Low PE
» High growth
» Low risk
» High ROE
Sources for ratio data
Value Line will provide you with every numbers/ratios but you will have to pay $598.