As I mentioned in the previous post, these ratios help us to understand companies value. Great companies can be a bad investment if you bought them at the wrong prices. This is like buying stuff from a supermarket to realize that the same item is selling at a 50% discount. Although in the case of stock prices, no one can predict its direction in the long run. It’s better to do some research on where the valuations are before you get hold of some of the shares.
As investors, we are in the game for the long run. Great companies always grow and increase in share prices in the long run. I meant a 5-10 years time horizon. While there are lots of companies listed in the exchange, many of them belong to the industry sector that we are familiar with. It’s about filtering out the best ones to produce great returns.
What Are Financial Ratios?
Financial ratios are some indicators of where the company stock is traded at. These help us to compare similar companies. It also helps us to understand the valuation level the company is being traded at. Value investors tend to stress a lot more on the valuations. They believe in buying great companies at a cheaper price. These ratios are to be used in conjunction with the other criteria mentioned in the previous post.
Why Are Financial Ratios Important?
These can help us to screen for companies for investing easier. If you are a value investor like the valuation at the core of your heart in assessing a company, these ratios can come in handy. If you have read the book intelligent investor by Benjamin Graham, you will see these ratios mentioned in all the case studies.
It’s debatable that new generation investors argue that value investing is for the old generations. We see the importance of valuations in times of market corrections and also in Bear markets. While markets are usually in the bull market territory with investors overlooking valuations. When everyone is optimistic, no one cares about valuations. When optimism is overtaken by pessimism, people will look for value in stocks they own.
P/E Ratio
The 2 variables used in the calculation of the P/E ratio are the stock price and the Earnings per share. Earnings per share are also called EPS. Earning per share is calculated by dividing the earnings by the total number of shares. The better the earnings, EPS will be better also. If the Earnings of the company is negative, the P/E Ratio will be negative also. P stands for the stock price.
When calculating the P/E ratio, you divide the stock price by the EPS. The smaller the PE ratio, the better. This means that your original investment amount is gained by the stock at a much faster rate. P/E ratio is useless if the company is cash-flow negative. This happens when the companies are at the early stages and not profitable. The higher the P/E ratio, it means that the company is overvalued. Growth stock investors tend to ignore this ratio and consider the PEG ratio instead.
Calculation of these ratios is not necessarily to be done by you. Most of the stock analysis platforms have these numbers calculated for you already. Platforms like Google/yahoo finance can be an example of these data aggregators.
PEG Ratio
Variables involved in the PEG ratio are the Price, EPS and EPS growth rate. EPS growth rate can be found from the analyst’s analysis. There are 2 ways in calculating the growth rate. Trailing growth rate by considering the rate of EPS growth from the last years vs the current years. Forward EPS is based on the expected earnings growth in the next 5 years and then calculating the rate per year.
Once you have the PE ratio, you may divide it by the earnings growth rate. The output of this is the PEg ratio. The smaller the number, the better. Even if a company is overvalued by the matrices of the PE ratio. If the company is increasing its EPS at a significant rate, it can become fairly valued and undervalued once the growth catch’s up. This is the case in most of the tech and innovative companies in the world right now. Tesla and Amazon are some examples.
P/B Ratio
Price is used again In the calculation of the P/B ratio. B in this ratio stands for the book value per share. Book value per share is calculated by removing the liabilities from assets and then dividing it by the number of shares outstanding. (Assets-Liabilities, intangibles and goodwill)/No of shares. A P/B ratio of 1 means that the stock is traded at a fair valuation. The smaller the number the better, that book value of your share is higher than the current share price. This means that the company is significantly undervalued.
P/B ratio is often used when valuing bank stocks and REITs which are asset-heavy. Startups that are growing very fast are not measured with the scales of the P/B ratio.
P/S Ratio
P in the P/S ratio also stands for the share price while S stands for the sales per share. S can be derived by dividing the total sales generated by the company by the total number of outstanding shares. Now that we have the sales per share calculated, this can be used to divide the current share price thus generating the P/S ratio. The smaller the ratio the better and anything above 5 is generally considered overvalued.
P/S or price to sales ratio is commonly used to evaluate growth companies that are aggressively in realms of sales and rapidly growing. This is because these companies are expected to grab more market share. With an increasing market share, customers will spend more with the company. This will increase revenues and future earnings.
Current Ratio
The current ratio indicates the current assets/current liabilities. These are the short term assets divided by the short term liabilities. In the event of a liquidation, the current ratio will tell us how likely Is the company’s chances to pay up debts in the short term and short term cash flow. Lenders would like to give loans to a company with a higher ratio for this.
These ratio standards will differ from industry to industry. A ratio less than 1 means that the company may face issues with the short term payments coming up. Chinese property developers like Evergrande are an example of this. Company management needs to constantly look at these numbers in the books to make sure that they handle the liquidity properly.
Drawbacks In Using Financial Ratios
As I mentioned in the individual sections, all ratios cannot be used as an indicator to value all companies. It should not be used to value and analyse companies in the different sectors and stages of the corporate lifecycle. Young tech startups can be better analysed with the PEG and P/S ratio. Banks and other asset-heavy companies are better analysed with the help of the P/B ratio. Companies that have been around for a long time and are profitable and growing slowly are better understood with the help of the P/E ratio.
You may not be able to qualify as many companies if you use all these ratios at once and use the same matrices. Use these ratios wisely. Keep in mind that the current ratio needs to be observed for all companies. Regardless of the sector, they are operating in and the lifecycle of the company. Ensure that the company has at least 1.5 times more current assets than its current liabilities.
How To Use Financial Ratios When Analysing Companies?
Based on your learning from this section, you can assign a score to the financial ratios and add it to the template I have shared in the previous post and also on the tools page. Put all these different aspects when you try to analyse a company for investing.
Summary
Conclusion
You can refer to the summary section as a cheat sheet of all the different ratios mentioned here. But, it is important to understand the tool before you use them. It is highly appreciated if you spend some time to understand the ratios and their meanings. As I mentioned throughout the post, use these ratios in your analysis along with the others. As there is no single metric to understand and analyze companies. Use the score table for your analysis and re-visit your findings yearly to see how the scores are changing.