7 important financial ratios to know when analyzing a stock
For investors looking to invest beyond 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 business.
A good place to start is to file a business with the Securities and Exchange Commission. These documents will provide a large amount of information, including the financial statements for the most recent year. From there, you can calculate financial ratios to help you understand the business and where the stock price might be heading.
Here are some key ratios to know when looking at a stock.
Earnings per share, or EPS, is one of the most commonly used ratios in the financial world. This number tells you how much a company earns in profit for each share in circulation. EPS is calculated by dividing a company’s net income by the total number of shares outstanding.
Knowing this ratio is important for equity investors, but understanding its limits is also crucial. Executives have a great deal of control over various accounting practices that can affect net income and earnings per share. Make sure you understand how profits are calculated and don’t just take EPS at face value.
Another common ratio is the P / E ratio, which takes a company’s share price and divides it by earnings per share. This is a valuation ratio, which means it is used by investors to determine how much value they are getting relative to what they are paying 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 at high rates. One of the world’s most successful investors, Warren Buffett, made his fortune buying stocks in companies with strong growth prospects that trade at low P / E ratios. An investment in Coca-Cola (KO) in the 1980s and a more recent investment in Apple (AAPL) when each was selling at a low P / E ratio brought in billions to Berkshire Hathaway shareholders.
P / E ratios can be calculated using future profits, or profits that have already been earned, as well as future profits, which are projections of what the business can earn in the future. For fast growing companies, it may be more useful to look at the forward P / E ratio than to use historical earnings which may cause the ratio to increase. But remember projections are not guaranteed, and many stocks of companies that were once considered fast growing suffered when that growth did not materialize.
The P / E ratio can also be inverted to calculate a profit return. By taking earnings per share and dividing by the share price, investors can easily compare the return to other investment opportunities.
One of the most important ratios to understand is return on equity, or the return that a company generates on the capital of its shareholders. In a sense, it’s a measure of a company’s ability to turn its shareholders’ money into more money. If you have two businesses that each made $ 1 million this year, but one business invested $ 10 million to generate that income while the other only needed $ 5 million, it would be clear. that the second company had a better activity that year.
In its simplest form, return on equity is calculated by dividing a company’s bottom line by its equity. Generally, the higher a company’s return on equity, the better its underlying business. But these high returns tend to attract other companies who are also interested in high returns, which could lead to increased competition. Increased competition is almost always negative for a business and can reduce once-high returns on equity to more normal levels.
4. Debt ratio
In addition to tracking the profitability of a business, you’ll also want to understand how the business is funded and whether it can handle the levels of debt it has. 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 indebted a company is. In general, debt ratios above 40% warrant further consideration to ensure that the business can manage the debt.
The type of financing used by a business will depend on the individual circumstances of that business. Firms that are more cyclical should rely less on debt financing to avoid potential defaults during economic downturns when incomes and profits tend to be lower. Conversely, companies with stable and consistent performance can often withstand 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 business can support its debt load. Interest coverage can be calculated by taking earnings before interest and taxes, or EBIT, and dividing by interest expense. This number tells you how well the income covers interest payments owed to bondholders. The higher the ratio, the more coverage the company has for its debt payments.
Remember, however, that income does not always stay the same. A cyclical business operating near a peak may display great interest coverage due to its high profits, but this can evaporate when profits fall. You will want to make sure that a business can meet its obligations under various economic conditions.
6. Company value versus EBIT
The enterprise value to EBIT ratio is essentially a more advanced version of the P / E ratio. The two ratios are a way for investors to measure the value they are getting versus what they are paying. But using enterprise value instead of the share price allows us to factor in any debt financing used by the business. This is how it works.
Enterprise value can be calculated by adding a company’s interest-bearing debt, net of cash, to its market capitalization. Then, by 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.
The operating margin is a way to measure the profitability of the main activities of a company. It is calculated by dividing operating profit by total revenue and shows how much revenue is generated per each dollar of sales.
Operating income takes income and subtracts cost of sales and all operating expenses, such as personnel and marketing costs. Calculating an operating margin can help you compare yourself to other businesses without having to adjust for differences in debt financing or tax rates.
At the end of the line
These ratios and others will help you understand a business, but they should always be viewed as a whole rather than focusing on one or two ratios. Financial analysis using ratios is just one step in the process of investing in a company’s shares. Also be sure to do some management research and read what they say about a business. Sometimes the things that cannot be easily measured matter the most to the future of a business.