KEY FINANCIAL RATIOS FOR EVALUATING STOCKS

The following are some of the financial metrics to understand to do a basic quantitative analysis for a Stock:

Rule of 72: If the number 72 is divided by the rate of return, we get the number of years it takes to double the principal. For example, if an investment returns 10%, it takes around 7 years for the principal to double. If the return is 5%, it takes around 14 years to double. This rule gives a quick way to do the math to evaluate an investment.

Price to Earnings (P/E): This is the Price/Earnings ratio and the one that is most referred to. The price of the Stock is divided by EPS (Earnings per share) to get this metric. This usually reflects if the stock is expensive or cheap. However this is not a number to look at in itself. The P/E of the sector and the competitors need to be taken into account as well. Also the earnings forecast for the company needs to be taken into consideration. If the outlook for future earnings is stable, that is a positive sign. For technology and other high flying stocks, this number is higher. For beaten down stocks and unfavorable sectors, this is lower. These sectors are where one can find hidden gems. If a company has no earnings, there is no number.

Price to Book (P/B): This is the Price/Book ratio. The book value per share is the total assets minus total liabilities, divided by the shares outstanding. If the stock price is divided by the book value per share, we get the P/B. If it is less than 1, it means there is a chance that the stock is undervalued. However the book value for bad companies is like an ice cube in the sun. It keeps melting away as the good will is getting written down due to bad acquisitions etc. If the number is between 0.75 and 1.5, there is a chance to find an undervalued stock.

Return on Equity: This is a key metric to evaluate a business. This is obtained by dividing the total earnings of a business by the equity (Total assets minus total liabilities). This number is better because it showcases the effectiveness of the management in generating returns. An increase in earnings alone is not a good measure of the effectiveness of management. Since the earnings can increase because of acquisitions etc, this cannot be used to judge the operations. Since we are dividing the income by equity, this takes into account the addition of capital into the business as well. If we read the letters of Warren Buffet, we find that he focuses a lot on this number rather than just the earnings.

Dividend yield: This is the dividend per stock / price * 100. This is the yield that you get back as dividends when you purchase the stock. There are blue chip stocks that return a lesser yield. There are some distressed stocks that return a meaty yield. However there are some companies which borrow money to return as dividends just to keep the share price afloat. Stay clear from these. Also an analysis should be made to see if a dividend is sustainable or not.

Percentage of earnings returned as dividends: Divide the earnings of a company (income statement) by the amount returned as dividends to the shareholders (Cash flow statement). Multiply by 100 to get the percentage. Always look for companies that give less than 40% of their earnings back as the dividend. The advantage would be that in case of a drop in earnings, the dividend would be sustainable.

Price/Free Cash flow: The free cash flow is the cash available after capital expenditures, paying debt service, dividends etc. This is the excess cash that a business throws out and a key measure for the health of a company. If the company has FCF, its a healthy sign. If the company is cash flow negative, the company may soon have to raise more cash for its operations including taking on debt or issuing new shares. The lower this number, the better is the stock.

Price/Sales: Divide the total market capitalization by the revenue. For growth stocks, this will be a high number whereas for unfavorable stocks, this will be quite low. The catch is that for high fliers, if ever there is a glitch in the revenue, the stock will get beaten down pretty bad.

Current Ratio: Divide the current assets by current liabilities. This tells us whether a company can pay its short term obligations to stay in business. A higher number gives the picture of a strong business whereas a number less than 1 signals an investor to take a pass on the investment. For retail stocks however, this maybe less than 1 and it may be a great business. This is because the strong retailers can negotiate the accounts payable to have a longer term, as well as keeping the inventory low due to an effective supply chain. However this ratio gives a quick picture to the solvency of a business.

Debt/Earnings: Divide the total debt (including short term and long term) by the earnings. This number should be less than 6. This indicates that the business will have no issues in servicing its debt. A higher number should signal a red flag that the company may default on its debt and may need to refinance or in the worst case, file for bankruptcy.

The following table summarizes these ratios: