Sunday, 15 April 2012

Value Investing - Important Financial Ratios

Important Ratios

The following is a simple discussion for the most important ratios a value investor should consider: 1. PE ratio, 2. PEG ratio, 3. Net profit margin , 4. Return on assets (ROA) , 5. Return on Equity (ROE), 6. Debt/Equity Ratio , 7. Current Ratio.

1). PE Ratio (P/E) 

Price/earnings ratio is the most common measure of how expensive a stock is. The P/E ratio is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period, usually the trailing period but occasionally the current or forward period.

In ordinary periods, most stocks trade between a 10-25 P/E ratio. Stocks with higher forecast earnings growth will usually have a higher P/E, and those expected to have lower earnings growth will in most cases have a lower P/E. Peter Lynch thinks the P/E ratio of any company that's fairly priced will equal to its growth rate.

The bottom line on Price/earnings ratio for the best value stock is: PE Ratio < 20

2). PE Ratio To Growth Ratio (PEG)

The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth. PEG is equal to P/E ratio divided by EPS growth ratio .

In general, the P/E ratio is higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

The PEG ratio is considered to be a convenient approximation. It was popularized by Peter Lynch. He thinks a fairly valued company will have its PEG equal to 1. So a lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive).

The bottom line on PEG ratio for the best value stock is: PEG < 1.

3). Net Profit Margin 

Net profit margin is a key method of measuring profitability which is calculated as net income divided by revenues, or net profits divided by sales . It can be interpreted as the amount of money the company gets to keep for every dollar of revenue. A 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have better control over its costs compared to its competitors and have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn.

The bottom line on net profit margin for the best value stock is: Net profit margin > 10%.

4). Return on Assets (ROA) 

ROA gives an idea as to how efficient management is at using its assets to generate earnings. An indicator of how profitable a company is relative to its total assets.

ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company.

For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit.

Management's most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.

The bottom line on return on assets for the best value stock is: Return on assets > 10%.

5). Return on Equity (ROE) 

ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income divided by total equity .

Buffett always looks at ROE to see whether or not a company has consistently performed well in comparison to other companies in the same industry. Looking at the ROE in just the last year isn't enough. The investor should view the ROE from the past five to 10 years to get a good idea of historical performance.

The bottom line on Return on Equity for the best value stock is: Return on Equity > 15%.

6). Debt to Equity Ratio

The debt/equity ratio is a key characteristic Buffett considers carefully. Buffett prefers to see a small amount of debt so that earnings growth is being generated from shareholders' equity as opposed to borrowed money.

The debt/equity ratio is a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The bottom line on debt/equity ratio for the best value stock is: Debt/Equity Ratio < 1.

7). Current Ratio 

The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations.

A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign.

The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.

The bottom line on current ratio for the best value stock is: Current Ratio > 1

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