Analyze investments quickly with ratios.
Stock picking can seem confusing, but using fundamental analysis and ratios can help you find long-term investing opportunities. Ratio analysis isn’t only for individual stock pickers, as this type of study also benefits fund investors. Financial ratios are used to compare stocks with peers and within an industry; some of the stats based on historical performance can yield a deeper understanding of asset value. While fundamental analysis may not guarantee a stock’s future success, it can serve as a useful way to measure it. Here are eight key investment ratios that will open the door to superior stock and fund analysis.
Divide a company’s share price by its annual earnings per share to calculate the P/E ratio. This ratio shows how much investors are willing to pay for $1 of a company’s earnings. “It is probably the best way of comparing assets in different sectors and of finding true bargains,” says Steven Jon Kaplan, CEO of True Contrarian Investments. Higher P/E ratios suggest a company’s future earnings are expected to grow and may appear overvalued compared with companies with lower P/Es. That said, a high or low P/E doesn’t necessarily indicate a good or bad investment; it offers a snapshot that begs additional inquiry. Given the uncertainty of future cash flows, it can be helpful for investors to rely on historical P/Es and use a mix of other ratios to evaluate and pick stocks.
Robert Johnson, professor of finance at Creighton University in Omaha, Nebraska, touts the benefits of calculating a stock’s price divided by sales per share, commonly referred to as the price-to-sales ratio. “The price-to-sales ratio is used by analysts who want to eliminate some of the distortions that can result in company earnings,” Johnson says. It’s a useful ratio to determine whether a company has earnings, cash flow or even positive book value since sales is always a positive number. A lower ratio suggests you’ve found a bargain, or a value stock. Industry consensus says lower P/S stocks have better value because investors are paying less for every dollar of a company’s revenues. P/S ratio values can vary across sectors, so to best assess a company’s P/S, compare it with industry peers.
Profit margin ratio
This is the amount of profit a company makes for every unit of sales. Investors calculate this ratio by dividing net profit over revenue. Profit margins are unique to an industry — with grocery chains known for low profit margins, while software companies can claim double-digit ratios. But this information doesn’t necessarily mean that it’s better to buy a software company than a grocery store stock. A high profit margin means a business can offer products priced higher than its costs, yielding profits through effective pricing strategies. A low profit margin may mean there are inefficient pricing strategies, where a business cannot produce enough profit to cover expenses. Any stock could be a winner with a growing revenue stream and steady profit margins.
Dividend payout ratio
Companies with rising dividend payments are favored by John Robinson, owner and founder of Nest Egg Guru in Hawaii. The dividend payout ratio is the percentage of net income paid to investors in the form of dividends. This ratio tells investors how much earnings are paid out in dividends versus how much is reinvested back into the company. The higher the percentage, the less money remains to reinvest back into growing the company. “Companies that pay out less than 60% of their earnings as dividends tend to have room for further dividend increases and the ability to withstand temporary earnings downturns without having to reduce or eliminate dividend payments,“ he says.
Price-free cash flow ratio
Tim Parker, a partner at Regency Wealth Management in New York City, reveres free cash flow because that is the amount of money left over after a company reinvests in the business to pay dividends, buy back shares or make acquisitions. To determine price-free cash flow, divide the company’s share price by the operating free cash flow per share. The ratio measures how much cash a company earns for each share of stock. Investors want to search for companies with growing free cash flow that are selling at a bargain. Parker favors this ratio since free cash flow is harder to manipulate than earnings. A lower ratio indicates a company may be undervalued, while a higher ratio may signal overvaluation.
Valuation ratios are important, but so are quality measures, such as debt and liquidity metrics. Divide a company’s total liabilities by its shareholder equity to compute the debt-equity ratio. This ratio explains a company’s financial leverage, the comparison between borrowed funds and equity or ownership. Think of this ratio like a homeowner’s mortgage value versus principal on the home. A greater proportion of debt constrains a company’s flexibility to grow as more revenue is directed to pay debt costs. Like most ratios, compare the debt-equity ratio to those of other industry members, as some sectors, such as utilities, have higher typical debt ratios compared with others.
Quick and current ratios
Sameer Samana, global equity and technical strategist at Wells Fargo Investment Institute in St. Louis, recommends examining the quick ratio and current ratio. These liquidity ratios measure if a company has enough working capital to handle potential downturns and financial setbacks. The current ratio divides current assets by current liabilities to measure how much cash a company has on hand to pay short-term obligations within a year. The quick ratio sums cash, marketable securities and accounts receivables and divides this sum by current liabilities. Higher numbers for these ratios suggest greater liquidity, while lower ratios may suggest a company cannot meet short-term obligations.
This metric is the company’s EBITDA — which is an abbreviation for earnings before interest, taxes, depreciation and amortization — divided by its net sales. This ratio is used to evaluate a company’s overall profitability or earnings before expenses, by comparing revenue with earnings. “The stability of EBITDA typically determines investors’ appetite for the amount of debt it believes the business should have,” says Bryan Lee, chief investment officer at Blue Zone Wealth Advisors in Los Angeles. “A more levered company brings higher volatility for how the equity trades. This volatility can amplify returns on the upside but also to the downside,” he says. EBITDA margin offers a transparent view into business operations by eliminating noncash or nonoperating expenses like interest costs, taxes and depreciation that may dim profits, giving a more precise view of a company’s profitability.
Investors should understand these financial ratios:
— Price-earnings ratio.
— Price-sales ratio.
— Profit margin ratio.
— Dividend payout ratio.
— Price-free cash flow ratio.
— Debt-equity ratio.
— Quick and current ratios.
— EBITDA-to-sales ratio.
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Update 12/28/20: This story was published at an earlier date and has been updated with new information.