For investors looking to invest outside of diversified mutual funds or ETFs, individual stocks can be a profitable option. But before you start buying individual stocks, you need to know how to analyze their underlying activities.
A good place to start is a company’s filings with the Securities and Exchange Commission. These filings will provide a large amount of information, including financial statements for the most recent year. From there, you can calculate financial ratios to increase your understanding of the company and where the stock price might go.
Here are the most important ratios investors need to know when looking at a stock.
1. Earnings per share (EPS)
Earnings per share, or EPS, is one of the most commonly used ratios in the financial world. This number indicates how much a company earns in profit for each share outstanding. Earnings per share are calculated by dividing a company’s net profit by the total number of shares outstanding.
Knowing this ratio is important for stock investors, but understanding its limits is also crucial. Executives have a lot of control over various accounting practices that can affect net income and earnings per share. Make sure you understand how earnings are calculated and don’t take earnings per share for granted.
2. Price-earnings ratio (P/E)
Another common financial ratio is the price-to-earnings ratio, which divides a company’s stock price by its earnings per share. This is a valuation ratio, which means investors use it to determine how much value they are getting relative to what they pay for a stock.
Profitable companies with average or below-average growth prospects tend to trade at lower price-to-earnings ratios than companies that are expected to grow quickly. One of the world’s most successful investors, Warren Buffett, has made a fortune buying shares in companies with solid growth prospects that trade at low price-to-earnings ratios. An investment in Coca-Cola (KO) in the 1980s and a more recent investment in Apple (AAPL), when both sold at a low price-to-earnings ratio, have generated billions for Berkshire Hathaway shareholders.
P/E ratios can be calculated based on rolling profits, or profits that have already been earned, as well as future profits, which are projections of what the company can earn in the future.
For fast-growing companies, it may be more useful to look at the future price-to-earnings ratio rather than using historical earnings that could push the ratio higher. But remember that projections are not guaranteed, and many stocks of companies once considered high-growth companies have suffered when that growth failed to materialize.
The price-to-earnings ratio can also be inverted to calculate earnings yield. By taking the earnings per share and dividing it by the stock price, investors can easily compare returns with other investment options.
3. Return on Equity (ROE)
One of the most important ratios for investors to understand is return on equity, or the return a company generates on its shareholder capital. In a sense, it’s a measure of how good a company is at turning its shareholders’ money into more money. If you have two companies that each earned $1 million this year, but one company invested $10 million to generate that revenue while the other only needed $5 million, it would be clear that the second company had a better business that year.
In its simplest form, return on equity is calculated by dividing a company’s net income by its shareholders’ equity. In general, the higher a company’s return on equity, the better its underlying business is. But these high returns often attract other companies that would also like to achieve high returns, potentially leading to more competition. More competition is almost always negative for a company and can reduce the once high return on equity to a more normal level.
4. Debt/capital ratio
In addition to tracking a company’s profitability, you also want to understand how the company is financed and whether it can support its debt burden. One way to look at this is the debt-to-capital ratio, which adds up short-term and long-term debt and divides it by the company’s total capital.
The higher the ratio, the more debt a company has. In general, debt-to-capital ratios above 40 percent warrant further examination to ensure the company can handle the debt load.
The type of financing a company uses depends on the individual circumstances of that company. Companies that are more cyclical should rely less on debt financing to avoid potential defaults during economic downturns, when revenues and profits are typically lower. Conversely, companies that perform stably and consistently can often support above-average debt levels due to their more predictable nature.
5. Interest Coverage Ratio (ICR)
The interest coverage ratio is another good way to measure whether a company can support the amount of debt it has. Interest coverage can be calculated by taking earnings before interest and taxes, or EBIT, and dividing it by interest expense. This number indicates the extent to which income covers interest payments to bondholders. The higher the ratio, the more coverage the company has for its debt payments.
However, remember that income does not always remain the same. A cyclical company operating near a peak may exhibit high interest coverage due to high earnings, but that can evaporate as earnings decline. You want to be sure that a company can meet its obligations under different economic conditions.
6. Business value versus EBIT
The enterprise value/EBIT ratio is essentially a more advanced version of the price/earnings ratio. Both ratios are a way for investors to measure how much value they are getting compared to what they are paying. But by using enterprise value instead of stock price, we can include all debt financing used by the company. Here’s how it works.
Enterprise value can be calculated by adding a company’s interest-bearing debt, net of cash, to its market capitalization, which is the total value of all its outstanding shares. Then, using EBIT you can more easily compare a company’s actual operating profits with other companies that may have different tax rates or debt levels.
7. Operating margin
Operating margin is a way to measure the profitability of a company’s core activities. It is calculated by dividing operating profit by total sales and shows how much income is generated by each dollar of sales.
The operating result takes the revenue and deducts the sales costs and all operating costs, such as personnel and marketing costs. Calculating an operating margin allows you to compare with other companies without having to adjust for differences in debt financing or tax rates.
8. Quick ratio
The quick ratio, also called the acid test, measures whether a company can meet its short-term obligations with assets that can be quickly converted into cash. The ratio is useful for analyzing companies experiencing financial difficulties or during economic recessions when it may be difficult to make profits.
The ratio adds up a company’s cash, marketable securities and accounts receivable and is divided by its current liabilities. All these figures can be found on the company’s most recent balance sheet. Importantly, inventory is excluded from the list of assets because it cannot be relied on for a quick conversion to cash.
If the ratio is one or less, the company may need to raise additional money from investors or hope that its business improves quickly.
In short
These and other financial ratios will enhance your understanding of a company, but they should always be viewed as a whole rather than focusing on just one or two ratios. Financial analysis using ratios is just one step in the process of investing in a company’s stock. Make sure you also research management and read what they say about a company. Sometimes the things that can’t easily be measured by financial ratios are the most important to a company’s future.
