How to select great companies based upon key financial ratios

By | March 16, 2015

An investor can quickly assess the financial health and performance of an investment by calculating these key financial ratios when looking at the financial statements of a company. Below are several important ratios to evaluate:

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Earnings Per Share (EPS)

EPS = Net Earnings Outstanding Shares
Earnings per share measures the amount of earnings for each share of stock outstanding. This is an important measurement because stock prices are driven by the earnings of a company. Usually EPS is used when comparing companies in the same industry, the higher the better. EPS is generally considered one of the most important variables in determining a company’s stock price. It serves as an indicator of a company’s profitability.

An important aspect of EPS that is often ignored is the capital used to generate these earnings. Two companies can have the same amount of earnings, but one company can produce the same amount with less investment. All else equal, that company would be more efficient at generating earnings with less investment than the other company, and that would be the superior company to invest in.

 

P/E or Price/Earnings ratio basically tells you how cheaply a stock is trading at based on its earnings.
P/E = Market Price Per ShareAnnual Earnings Per Share
For example, if stock XYZ is trading at a stock price of $20 and the earnings per share for the most recent 12 month period is $4, then stock A has a P/E ratio of 5 (20/4). The purchaser of the stock is paying $5 for every dollar of earnings of the company. When a company has a loss (negative earnings) or no profit, then it has an undefined P/E ratio.

In general terms, the lower the P/E ratio is for a company, the cheaper it is for the earnings it generates. Oftentimes companies that are expected to have higher potential to grow with have really high P/E ratios. For example, internet startups will often have high P/E ratios because the investors buying the stock will see a possibility for exponential growth. Think of the hype when pets.com first had its IPO. In contrast, a telecommunications company like At&t has a lower P/E ratio because the future growth is likely as high as a startup.

 

PEG Ratio, this measure determines the relative trade off between the price of a stock, the earnings generated per share (EPS), and the company’s expected growth.
PEG = P/E / Annual EPS Growth
The growth rate is expressed as a percentage above 100%, and should use real growth only, to correct for inflation. E.g. if a company is growing at 30% a year, and has a P/E of 30, it would have a PEG of 1.

Typically the lower the ratio the cheaper it is (better), and the higher it is, the more expensive the stock is (worse).

PEG is used to find if a stock is under or overvalued. A company with a PEG ratio of 1 is said to be trading at a fair value. PEG ratio is most useful when evaluating companies with high growth potential, for companies that have limited/slower growth, it is less accurate. Usually these companies offer an attractive dividend to offset the lure of high growth.

ROE, ROE is expressed as a percentage and calculated as:
Return on Equity = Annual Net Income(after tax)/Shareholder’s Equity

 

Shareholder’s equity is the shareholder’s ownership of the company and can be calculated by taking the assets and subtracting the liabilities. Assets – Liabilities = Shareholder’s equity.

ROE is important because it basically measures how much profit a company can generate based on the investment shareholders have made. It is best used to compare companies in the same industry to determine which is best at providing good returns with investor’s money.

From the balance sheet we can use two measures of liquidity:

The Current ratio, which is current assets/current liabilities, measures how much of its most liquid assets it has on hand to pay off its liabilities. The higher the number, the better it is to remaining solvent. 2 is a good number to start.

The Acid Test ratio gives a clear view of a company’s cash position. The Acid Test ratio is (cash + accounts receivable + short term investments) / current liabilities.

From there, we take a look at its long term assets found below current assets (real estate, factories, warehouses, equipment, and investments).

So now you know some basic financial ratios to help determine if a company is healthy or not. Think of this method as just taking a snap shot of a company to initially see if the company is operating well or not.

 

Cheers,

 

Sam

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