10 numbers every investor should know
10 numbers every investor should know
Savvy stock pickers know that a few simple formulas and a little math can reveal the difference between a buy and a bust. Here are 10 key investing ratios, what they mean and how to use them.
Evaluating stocks to buy and sell can be a tricky business, even with all of the data available at your fingertips. Out of the dozens of ratios and metrics that give clues to the financial health of a company, a few of them are extremely useful for their simplicity and effectiveness.
Here are 10 financial ratios that can tell you most of what you need to know when you’re scouring the market for good stocks to buy.
This number tells you how many years’ worth of profits you’re paying for a stock. You calculate it by dividing earnings per share by the stock price. All things equal, the lower the P/E the better. The most frequently used earnings number in the calculation is the total earnings per share over the past four reported quarters. You could also use “forward” earnings, which is the average of Wall Street’s forecasts for the current fiscal year.
Benjamin Graham, the legendary investor and Warren Buffett’s teacher at Columbia University, postulated that stocks should trade for a P/E multiple equal to 8.5 times earnings plus two times the growth rate of earnings.
Without some context, the P/E has limited value in finding cheap stocks. For the market as a whole, theS&P 500 Index ($INX) currently trades for 19.47 times the past 12 months of reported earnings. The average P/E since 1935 is 15.86, suggesting the market is a bit pricey.
Some industries like homebuilders and commodity producers tend to trade at low P/E multiples because earnings tumble in a hurry so investors don’t want to pay too dearly. Rapidly growing companies like Netflix(NFLX), with a P/E of 382, or Facebook (FB), trading for 222 times earnings, are valued much more on the hope of future profits that bring the P/E down to something more modest.
For individual stocks, you should compare a stock’s P/E with those of its competitors. It’s also usually informative to compare the current P/E with the average multiple over the past three, five or even 10 years. If it’s lower than average, it’s a sign that you’ve spotted a possible bargain — but that all depends on growth, which leads us into the next ratio to watch, the PEG ratio.
The PEG ratio is another Benjamin Graham invention which attempts to measure the degree of a discount or premium you’re paying for growth. The calculation is to divide the P/E ratio by the long-term annualized percentage growth rate of earnings, ideally the next five years’ worth. A result of less than 1.0 implies that the market is not fully valuing the prospects for future growth.
The downside of the PEG ratio is that future growth rates are notoriously hard to predict. Companies’ growth profiles can change, sometimes drastically. Apple (AAPL) is a good example. It trades at a svelte 0.86 PEG ratio based on a P/E of 12.2 and a five-year EPS growth rate of 14.5 percent annualized. That’s appreciably lower than the 72 percent growth rate over the past five years, but still enough, if it materializes, to suggest that Apple buyers are getting a bargain.
Similar to the P/E ratio, the price-to-sales ratio divides the market capitalization of a stock by total sales over the past 12 months, instead of earnings. Popularized by investment manager and longtime Forbes columnist Ken Fisher, the price-sales ratio tells you how much you are paying for every dollar in annual sales.
Because there are times when cyclical companies have no earnings, the price-sales multiple can be a better indicator of a company’s relative value than the P/E. Like other ratios, you should compare the P/S of a stock of those with competitors and with historical sales multiples. Sales are also more difficult to manipulate than earnings, giving a more reliable gauge of value. Keep in mind, however, that the beauty of a low P/S ratio can be spoiled by a constant lack of profitability and large levels of debt.
This useful measure of value is obtained by dividing the market value by operating cash flow over the prior 12 months. It strips out items like amortization and depreciation from earnings and focuses on cash generated by the business. This provides a better way than P/E for comparing valuations of companies from different countries that have different depreciation rules that can affect earnings.
Lower readings are preferable but keep in mind that there is more to cash flow than what comes from operations. Free cash flow is what’s left over after paying down debt, buying back stock and paying dividends. Negative free cash flow is forgivable as long it’s not a chronic problem, but companies that cannot produce positive cash flow from their core business operations can face eventual liquidity and solvency issues.
This ratio tells you how much you’re paying for every dollar of assets owned by the company, and you calculate it by dividing the market capitalization by the difference between total assets and total liabilities. The idea is to approximate how much money you could put your hands on if you shut down the business and sold off everything. As with most price multiple metrics, price-to-book is best used by comparing present multiples to historical averages.
The metric can be useful for comparing companies within asset-intensive businesses but service-oriented businesses or those without substantial property, plant and equipment typically have little book value and trade at sky-high P/BV multiples. For instance, United States Steel (X) trades for 0.87 times book value, while LinkedIn (LNKD) fetches an astronomical multiple of 24.8 times book value.
The fundamental accounting equation tells you that assets equal liabilities plus equity. The debt-to-equity ratio is a measure of financial leverage telling you the percentage of a company’s assets financed by debt.
The formula is to divide total debt (or just long-term debt) by shareholder’s equity, two items both found on the balance sheet. Off-balance sheet items like pension obligations should also be treated as debt.
Lower numbers are generally preferred because high debt loads can turn into big problems in a downturn. Debt cuts both ways, however, and taking on more debt during expansionary times gives a boost to profits. Heavy established industries like utilities and industrials generally have higher debt-equity ratios than rapidly growing companies that may carry little or no debt at all. Caterpillar (CAT) has a debt-equity ratio of 2.24, while Google’s (GOOG) is 0.62. The best comparisons are within industries and against a company’s historical ratios.
ROE measures a company’s efficiency at generating profits from money invested in the company, and it is derived by dividing by net income by shareholder’s equity. It’s a very handy measure of management’s effectiveness but it’s not useful for ascertaining value of early-stage companies that do not produce profits. For example, Tesla Motors (TSLA) has a -115 percent return on equity.
When comparing competing investments, stocks with higher ROE demonstrate that they can produce more profit from each dollar of equity and, all else equal, should be considered the superior choice.
Similar to return on equity, return on assets is a measure of management effectiveness obtained by dividing net income by total assets. A company with a higher ROA is usually preferable to one with a lower ROA, since it shows the ability to grow profits more efficiently from a given base of assets.
Companies with comparatively low ROA will need to borrow or raise equity to achieve the same amount of profit. ROA is most useful for intra-industry comparisons and the trend over a multiyear period can be more instructive than ROA for a single year or quarter.
Rising sales are great but they’re not so wonderful if they come at the expense of profit. Profit margin shows how much a company earns from each dollar of sales and is arrived at by dividing profit by sales. The number you get depends on the kind of profit you choose. Gross profit, which is sales minus cost of sales, is the simplest measure. Operating profit is gross profit less overhead items, and net profit (income) is what’s left after paying taxes.
Margins vary widely by industry and tend to be highest among manufacturers and decrease down the value chain to wholesalers and eventually retailers. Operating profit margin generally provides the best overall measure of profitability from ongoing business activities. Be aware that declining margins over time require higher levels of revenue to maintain profits at current levels.
If you are looking for yield from your equities, a fat dividend yield can appear quite enticing, especially in a low interest rate environment. The danger of a high yield is that it can be unsustainable, and when it’s eventually cut, you not only lose out on the income but the share price will often take a hit.
The dividend payout ratio is computed by dividing earnings per share by annual dividends per share. You want this to be less than 1.0, although real estate investment trusts (REITs), master limited partnerships (MLPs) and business development companies are required to pay out nearly all net income to avoid taxation at the corporate level. It is true that earnings include many non-cash items so you will also want to check out the cash payout ratio, which is operating cash flow per share divided by dividends per share. The lower the dividend payout ratio, the greater are the chances that the company will be able to sustain and hike the payout down the road.
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