101 Stock Market; The ratios every successful investor must know
Investing does not have to be a gamble
Buying stocks doesn’t have to be a gamble. The wrong way of buying stocks is to buy overpriced shares of the coffee shop company that sells the overpriced iced coffees you enjoy or to buy shares of the company of the smartphone you just bought because you enjoyed its HD camera. Consumer satisfaction is very important. However, there are many other relevant aspects you must consider to avoid gambling with stocks.
Looking only at the stock price tag is misleading. Some important accounting ratios should guide our decisions. Instead of memorizing them, one has to know what they represent and look at patterns over time, while comparing trends across different companies of the same sector. As you can imagine an airline has to burn much more revenue on operations, than a software company (eg; airplane maintenance and fuel).
Before looking at the ratios, the question is where to look? Many finance websites and eBroker offer you some key ratios (such as MSN Money, Yahoo Finance, Morningstar). When you find the stock you like, apart from checking its current price tag, you should look at its financial statements (Balance sheet, Income statement, and Cash flow statement). Which can be found at 10K filling in the SEC website.
We can argue, what if instead of learning how to hand-picking stocks I follow the market by investing exchange-traded fund (ETF), which a portfolio that includes all S&P 500 Index (as Vanguard’s VOO) or if I invest in an ITF for high dividend companies (as iShares HDV). Yes, these are possible alternatives. But regardless of your strategy (only ETFs, only stocks, or both), it is always useful to understand what you are buying. Remember, from a value investing perspective, you should buy I stock as if you were buying the underlying company.
Now with these 4 things (price and these three finantial statements) we can scroll down and calculate all ratios. Once you invest some time following and understanding this, it will become automatic. You do not have to be an accountant to understand these.
1) Profitability ratios
These ratios tell how good the company is at making a profit. It is the reason why most of us invest.
1.1) Profit margin (Net profit margin)
Using accounting jargon this key ratio is a measure of the “bottom-line” (income after all expenses, such as raw materials and salaries, taxes, and interests) over the “top-line” (how much money you get in sales/revenue). In other words, it tells you what is the final % of the money you keep as a profit from the initial bulk paid by clients.
Question: For every $ of revenue, how much money does a company get after all costs? Or, what percentage of my sales do I keep as profit in the end?
How to read: If profit margin=0.07 (7%), it means that for every $1 of sales/revenue the company keeps 7 cents ($0.07) as final profit.
1.2) ROS — Return on sales (operating margin)
This is a measure of how efficiently a company turns sales into profits. Unlike profit margin, instead of focusing the “top-line”, we look at the EBIT over revenue. EBIT meaning earnings before interests and sales. Because interests and sales vary across regions and sectors, EBIT gives a number that is easier to compare between companies more directly. It is the same as operating profit.
Question: For every $ of revenue, how much money does a company get (before paying taxes and interests) after all costs?
How to read: A 21% net profit margin means that for every $ of sales, the company keeps $0.21 as profit (before taxes and interest). The higher the better.
1.3) ROA — Returns on assets
This ratio tells how good the company is at turning “assets into money”. If you have two companies of the same sector (eg; consumer goods) discrepant ROA will tell you than one of the companies is much more efficient at making more dollars from the same assets (eg; raw materials).
Note: Total average Assets (from Balance sheet); average means the average assets between two consecutive years ((year1 assets + year2 assets)/ 2)
Question: How many $ of (annual) income I get for $1 of assets?
How to read: if ROA = 6.5%, it means the company turned every $1 of assets into 6.5 cents ($0.065) of profit. The higher the better.
1.4) ROE — Returns on equity
This ratio tells you how good the company is at turning investors’ money (equity) into earnings.
Question: How many $ of (annual) income I get for $1 of equity?
How to read: ROE = 6.5%, means the company turned every $1 of equity into 6.5 cents ($0.065) of profit. The higher the better.
Hint: Warren Buffett usually buys companies with a ROE>8% over the last last 10 years.
DuPont analysis is a subject that will be further assessed in our next 101Stock Market. This analysis, created by the DuPont corporation, allows breaking down ROE into its drivers.
2) Liquidity ratios
Most companies go bankrupt because they run out of cash.
Liquidity ratios are all about investment risk. These indexes take into account the available capital does pay debts and keep things running. Liquidity is a measure of a company’s ability to cover its immediate debts (eg; available cash or cash-equivalents).
2.1) Current ratio
Current means 12 months (per convention). Current assets are assets that can be turned into cash in <12 months (usually property, plant, and equipment is obviously out of this category). Current liabilities mean all debts that must be paid <12 months.
Question: How many times is a company able to pay its current debt using its current assets?
How to read: current ratio = 2.0, the company can use its current assets to pay all current liabilities twice; if quick ratio = 0.5, the company can use its current assets to pay only half of its current liabilities. The higher the better.
Caveat: Current ratio and quick ratio are snapshots (as everything on the Balance sheet). The cycle for the company’s collections and payment may not be currently captured. The company may receive its payables one month after.
Hint: Warren Buffet usually buys companies with a Current ratio>1.5
2.2) Quick ratio (acid test)
Since usually you cannot sell all your inventory and since you cannot get a refund for your prepaid expenses, these 2 categories of current assets cannot be turned into cash(equivalents) in 12 months. The quick ratio, aka acid test, can tell you more realistically how liquid the company is.
Question: How many times is a company able to pay its current debt using its current assets?
How to read: Quick ratio = 2.0, the company can pay all current liabilities twice; if quick ratio = 0.5, the company is only able to pay half of its current liabilities. The higher the better.
3) Leverage ratios (or Solvency ratio)
Now, you may be thinking “Solvency? but we already looked at liquidity”. Liquidity and solvency may look similar but they are not.
As stated before, liquidity tells you whether or not you have money at a given time to keep paying your bills (it is like paying for commodities even if you have a loan) while solvency tells you whether you have money/assets to pay all your debts.
Another article of this series will cover some examples in depth with great examples!
3.1) Interest coverage or Times Interest earned (TIE)
This simple ratio, which looks at the income statement, tells whether a company can use its cash from operations to pay for interests.
Note: For total interest expense, we consider only the interest and not the whole value of the respective liabilities.
Question: How many times can the company cover its interest expense using its income?
How to read: TIE=3.5, means the company has enough earnings to cover all its interests 3.5 times.
3.2) Debt to assets
This ratio measures to which extent assets are financed by creditors instead of investors.
Question: What percentage of assets is funded by borrowing compared with the percentage of resources that are funded by the investors.
How to read: If the debt to asset=0.6 it means that every $1 of equity is funded by $0.40 of shareholders equity and $0.60 of debt (liability).
3.3) Debt to capitalization
The ratio measures a company’s capital structure, financial solvency, and degree of leverage, at a particular point in time.
Here the denominator is the total capital regardless of the source (debt and equity).
Question: How much (%) of the total company comes from debt?
How to read: If the debt to capitalization=0.4 means that for every $1 of capital $0.40 were borrowed
3.4) Debt to equity (D/E)
Another way of understanding this ratio is the following. If you sell a company $1,000,000.00 assets and pay all liabilities $700,000, you are left with $300,000.00 (equity) (Equity = Assets — Liabilities). If you divide the remaining equity by the number of shares, then you have the Book value of each share. If liabilities are higher than the equity (D/E>1.0) and the company is to close doors and sell all its assent, you will have a negative balance (negative equity) and debt to pay (not you as a shareholder, but the company would have a negative balance). That why this ratio is so important.
Question: How much $ on debt there are for each $1 on equity?
How to read: D/E=0.7 means that for each $1 on equity there are $0.70 on debt. The lower the better.
Hint: Warren Buffet usually pick stock from companies with a D/E ratio <0.5. However this is highly dependent of industries (finance tends to have by nature higher D/E ratios.
4) Operating ratios
These ratios are essential from a management perspective but are the least important for an investor (not to be ignored).
4.1) Assets turnover
Similar to Returns on assets but here we measure revenue (top-line) instead of net income (bottom-line). It tells how efficient a company is turning its assets into revenue.
Question: How many $ of revenue the company gets from $1 of assets.
How to read: If assets turnover=0.05. It means the (annual) revenue is 5% of the total assets. Or that the company gets 5 cents ($0.05) a year for each 1$ in assets.
4.2) Inventory turnover
Imagine you have tons of dairy products waiting on the shelves unsold. It’s a financial nightmare. Inventory turnover tells how many times the company has replaced its inventory over a period.
Cost of goods sold (GOGS): Cost of acquiring/manufacturing products to be sold. This includes cost of labor, materials, and manufacturing.
Question: How many times a company sells all its inventory on a given year?
How to read: Inventory turnover= 10, means that the company sold 10 times its inventory.
Caveat: A high inventory turnover may mean that the company is efficient at selling its inventory OR that the company has bad planning being often without inventory to meet consumers’ demand.
4.3) Days in inventory
The inventory turnover (approached above 4.2) is needed to measure the days in inventory. It provides very similar information using the number of days as a measure (but in this case the lower the better).
Question: How many days a piece of inventory is kept on the company before being sold?
How to read: If days in inventory=60 its means the company has a product ready to sell on their shelves for 60 days after being sold. The shorter the better.
4.4) Receivables collection period
After selling its inventory a company has to be paid for it. It can be paid right away or the client may owe to pay in a future date. The receivables collection period measures how quickly to company can get the money it made from its sales. The lower the ratio the faster the cash collection.
Account receivable means money that the clients owe (will get) for goods or services already delivered by the company. It’s cash that the company will get.
Question: How many days does the company take to get back all its accounts receivable (money other people owe) from clients?
How to read: If receivable collection period=45. It means the company usually takes 45 days to get its money back from clients (from sales on credit). The shorter the better.
The part you were expecting. I am paying the right price? It is all about valuation.
Now that you now your company it’s time to check if you should be paying the asked price (at the stock market). Here come valuation measures.
Up until now all ratios were price independent, meaning you could calculate them based only on the accounting books regardless of the stock price. When looking at valuation indexes, we want to compare prices (at that specific time of the day) to its value.
5.1) Earnings per share (EPS)
This ratio tells you how many $/year a shareholder gets from each share. One must understand that not all earnings are paid in dividends (in fact many companies, including blue-chip companies, do NOT pay dividends at all). Part or all of these earnings may be reinvested (a choice made by each company).
Note: Prefered dividend is the dividend paid to owners of prefered stock (vs common stock)
Question: How many $ I am earning for each share I buy? (here the denominator is one share unit and not currency)
How to read: EPS=12.5, means, as a shareholder, I get $12.5 a year for each share I bought (regardless of its price).
Hint: Warren Buffets usually buys companies with a growing EPS for the last 10 years.
5.2) Price to earnings ratio (P/E)
This one measures how much investors are willing to pay compared to the profitability of the underlying business. Imagine there is a very profitable lemonade stand that makes $100,000/year of income. How much are you willing to pay to buy the stand and have this $100,000/year of income for the rest of your life (assuming life is perfect and things will be always as profitable). This is the key idea behind P/E.
Question: How many $ am I paying to get $1 of (annual) earnings?
How to read: P/E=25, means that I am paying $25 to get 1$ of (annual) earnings. The lower the better. Looking at the inverse (1/20), it means that I will get 4% returns/year of the paid price. In other words it will take 25 years to get the investment back in returns (which may go to dividends or may be reinvested into the company).
Buffett’s hint: P/E<1/15, to give you at least 7% of annual return.
5.3) Price to book value (P/B)
One of the most intuitive ratios. Imagine I am selling you a house with a $250,000 value for $300,000. The price to value ratio will be (300,000/250,000) 1,2. This means you are going to pay 1,2 times the value of the house. The same applies to companies and stock; here we compare the stock price to its book value (total equity/nº of shares, remember book value is the “equity” of a single share).
Question: How many $ am I paying to get $1 of equity?
How to read: P/B=3.2, means that I am paying $3.2 to get 1$ of equity. The lower the better.
5.4) Dividends payout ratio
This is one of the favorite topics of dividend investors. How much do I get in yearly dividends?
Question: From each 1$ in equity, how many $ I am receiving as a dividend?
How to read: DPR=0.04 means that for $1 in equity you will get 4 cents ($0.04) in dividends.
Even when reinvested, dividends are a relatively tax-inefficient income (especially for many non-US investors that bought US companies)
Hint: There is no right number. Many companies simply do not pay dividends. Others, like the dividend aristocrats, pay a significant amount. But careful, it is is too high (Eg; 70%) the company will be left with no profit to reinvest.
Remember in the beginning we talked about buying an underprice company (price << intrinsic value). However, we did not talk yet about HOW to calculate the intrinsic value. This is covered in-depth in another article on the Free cash flow equation for valuation.
I am not a financial advisor and none of this is intended to be financial advice I am only sharing my personal experience.
I have no relationship with any of the recommended sources.