Introduction to Financial Ratios
This article is an introduction to financial ratios used in stock analysis. While certainly not an exhaustive list, this article should provide a foundation for you to expand your vocabulary as you learn to invest for yourself.
This is important. Important because unless you have a university degree in finance or economics, this might be where many new investors get lost. How do you calculate price-to-sales? Which accounts do I include or exclude in EBITDA? Are there any accounting adjustments I should worry about??
Fortunately, all this work has already been done for you. BUT, if you are a geek like me and want to know how the numbers work, I recommend using Investopedia.com for more details. But for this article, it’s enough to know which ratios are important to look for and obtain a basic understanding of what they mean.
There are scores of financial ratios in stock analysis, however, here are three of the top financial ratios to consider when performing your due diligence:
1. Low Price to Earnings Multiples
2. Low Cash Flow Multiples
3. Discount to Book/Net Asset Value
Keep in mind that there is no such thing as a list of BEST financial ratios for value investing, or any form of stock analysis for that matter. Opinions differ on which ratios are the most useful, so don’t get confused. Find ratios that you understand, and increase your knowledge base as you get more experience investing. As I mentioned before, Investopedia is a really good resource, and it’s FREE, so be sure to add it to your toolbox.
Starting with the first ratio on our list, this is a ratio you will see most often referred to in newspapers and investment literature:
Low Price to Earnings Multiples, aka PE Ratio
The price-to-earnings ratio represents how many dollars you are paying for every dollar earned by the company. For example, if the PE ratio of a stock is 10, that means you are paying $10 for every $1 of the company’s earnings, and so on.
For Value Investing, you search for stocks that trade at low price-to-earnings multiples.
PE is usually dependent on the industry you are analyzing, for example, a utility company will probably have a lower PE ratio, generally speaking, than tech companies. Therefore, be aware that a low PE for one industry may be a high PE ratio for another industry.
Therefore, the more you can compare a company’s PE to other companies in their industry, and the lower the PE on a relative basis, generally speaking this will lower he risk of overpaying for a company’s stock.
Low Cash Flow Multiples
This ratio is similar to the PE ratio, except it removes all the effect of depreciation and non-cash items and deals solely with cash flow.
As with the PE ratio, whether a cash flow multiple is low or high is industry specific, but look for companies trading at lower multiples on a comparative basis to avoid overpaying for a company’s ability to generate cash from operations, investments and financing activities.
This ratio is really useful in uncovering “dirt cheap” stocks, especially when combined with the PE ratio and the next ratio below.
Discount to Book/Net Asset Value
Book value is theoretically the value of the company’s assets less its liabilities.
For our purposes though, a discount to book value represents stocks that are significantly undervalued and/or prime takeover candidates.
Think of it this way: If a company traded on for LESS than its books value, there is larger potential for upside opportunity and margin of safety.
Treasure Hunting: Using Stock Screeners
But how do we know if this company is a good investment? How do we know if ANY of these stocks on our short list is a good investment??
This is why a stock screener, a FREE online tool, is so useful! Imagine looking at over 2000 stocks on the NYSE and 1500 on the TSX, plus international exchanges easily puts us at over 10,000 stocks!!! Where do you start?
It’s all about the process of elimination, and to avoid overwhelm we have to make choices.
How To Use Yahoo! Finance Stock Screener.
Search for the term “Yahoo! Finance stock screener,” choose your industry, an exchange, enter your desired investment criteria using the ratios we’ve discussed above as your initial guide, and hit “Find Stocks.”
Continue to refine and narrow your investment criteria until you receive a manageable short list.
Don’t forget this list is DYNAMIC! As the prices fluctuate every day and every moment, your list will be difference every day. So don’t get caught up in the day-to-day fluctuations!
Focus on creating your shortlist.
Qualitative Research Criteria
From this short list you can examine each stock more closely based on other considerations, or what we call QUALITATIVE ANALYSIS.
Okay, so we have our shortlist based on the financial criteria you have chosen. And we’ve reduced our list of 10,000 stocks to 20-30 potentials.
And now that we’ve found some potential candidates, here are some additional non-financial factors, or qualitative factors, to consider:
Other Considerations or Qualitative Factors
1. Hidden Assets
Some examples of hidden assets could include tax-loss carry forwards, over-funded pension funds, real estate, potential spin offs, and favorable litigation outcomes, amongst others.
Good management is obviously key to a company’s short and long term success. There are two broad types of management to look out for:
a) Solid, proactive management
b) Poor or discredited management, which leaves a company ripe for an acquisition or merger
3. Discounted Valuation Compared To Its Peers
Discounted valuations metrics such a price to earnings, cash flow, discount to book value, and others, could make the company a prime candidate for a take-over by a relatively expensive domestic or foreign competitor looking for growth opportunities, market expansion, and simply the elimination of competition from the market.
Obviously this article does not include all the investment criteria, be it financial or non-financial, that you can use for making your own investment decisions. However, it IS enough to introduce you to the idea of doing your own fundamental research, try out a few stocks, and then continue to learn more as you gain more experience. Our upcoming courses will hold you by the hand and walk through live examples of this.
To Your Investing Success,
Kevin & Ali
The 360 Investing Guys