CommonLounge Archive

Financial Ratio Analysis — How to Evaluate Stocks and Stock Ratios

February 20, 2018

Ratio Analysis

Ratios are relationships between two numbers. For example, the ratio of current assets to total asset is one ratio related to the structure of assets. They help stakeholders assess the performance of companies, make it easier to compare their performance by using unified measures, and help investors understand the business models of companies.

Ratio analysis answers the following questions about a company:

  • How is the company doing — does it make healthy profits?
  • Does it use its cash and other assets in an effective manner?
  • Is it highly leveraged (has taken a lot of borrowed capital) and is it capable of paying interest on this borrowed capital on time?
  • What are its profit margins compared to its peers?
  • Is the company cheap or expensive compared to its peers?

Ratio analysis is a good approach to analyzing a company. It answers many questions which financial statements cannot answer in isolation. It forms the core for fundamental analysis. Ratios of one company must be compared with ratios of similar companies in the same industry (also known as Relative or Comparable Analysis). The following are certain types of ratios that help us in understanding a business:

  • Liquidity Ratios: These reflect the short term cash position of a company. It determines whether the company is self sufficient to fund its day to day operations (working capital management) or even if it holds excessive cash compared to its peers.
  • Profitability Ratios: These ratios reflect the profitability of a firm by depicting profit margins for the business. When a firm has very good operating margins but very low net profit margins (net profit is revenues minus expenses, and net profit margin is net profit/revenue), profitability ratios help us identify the root cause for such discrepancies and the ongoing trend in the industry as a whole.
  • Valuation Ratios: They act as an effective tool in helping us decide whether the company is fairly priced, undervalued or overvalued when compared with its peers. They also help determine the right entry and exit points when considering a Buy or Sell decision.
  • Efficiency Ratios: Also known as activity ratios, they help us analyze how efficiently the company manages its receivables, payables and inventory — essentially its entire operations. They provide evidence of how efficiently sales are converted to cash (Working capital cycle) in comparison to its peers.
  • Solvency Ratios: These ratios help us discover the proportion of the leverage (borrowed capital) that the company holds, whether it is inclined towards debt or it uses its own money to run its business. This ratio can also help us determine how effective the company is in generating cash to pay off its interest.
  • Other ratio groups include: cost structure ratios, asset structure ratios, and capital structure ratios.

Liquidity Ratio

Current Ratio

Let’s first define assets and liabilities.

Assets are items that are valuable or generate value to the organization. They usually contribute to making income in one way or another, or contribute in achieving the goals of the organization. Examples include: property, inventory, cash, … etc.

Liabilities are obligations that the company must pay at a certain point in time or when requested. Examples include: credit from suppliers (accounts payable), long term debt, and others.

The Current ratio tells us about the company’s ability to run its operations or to fund its short and long term obligations (Short term obligations are borrowings to be paid in current year). Higher current assets in comparison to current liabilities indicate a higher financial strength of the company. Current ratio greater than 1 (>1) is considered healthy but very high levels of current ratio are not good for any business. Higher levels of current ratio indicates too much of current assets since they do not generate any cash and are unproductive in nature. It is called current ratio because it includes all current assets.

It should not be seen in isolation — instead it should be compared with relevant peers since current ratio can vary with industry.

Current ratio = Current Assets / Current Liabilities

Quick Ratio

Also known as “Acid Test Ratio”, it measures the ability of the company to pay off its liabilities immediately. If all the current liabilities become due tomorrow, will the company be ale to pay them off from its current liquid assets (i.e. assets which can immediately be converted to cash)?

The equation for calculating quick ratio excludes inventory from current assets since it is not quickly convertible to cash. It includes receivables, which are amounts of money to be paid at a later due date by customers of the company, to whom the company sells on credit.

Quick Assets = Current Assets (Cash + Receivables + Current Investments) - Inventories

Quick Ratio = Quick Assets / Current Liabilities

A quick ratio equal to 1 indicates a strong short term financial position held by the firm. While some companies are highly dependent on inventories, having lower quick ratios, it is not a good practice to compare such companies with other firms having lower inventory-dependence. Take the case of Costco which has a Quick Ratio of 0.43 while Walmart has quick ratio of just 0.22. This shows that Costco has better ability to meet its liabilities than Walmart, who relies more on leverage (borrowed money to carry out its operations)

Profitability Ratios

Return on Assets (ROA)

ROA is used to measure the profitability of assets. It measures how efficient the company’s assets are. The higher the efficiency of assets, the more profit they will generate. It is not relevant for companies with asset-light business models (service or software companies) since they don’t have many assets (their ROA would be very high). The ratio is much more relevant for companies with sizable asset base or for banks.

In the balance sheet, items can be valued either at their historical cost price or market price (for example, inventory items can be valued at cost or market price). A bank’s balance sheet is at market prices which makes ROA a relevant parameter to compare it with peers.

ROA = Net Profit / Average Assets

Since net profit is earned during the year, but the balance sheet is for a particular date, average assets are used.

Return on Equity (ROE)

One of the most crucial ratio for Equity investors, it tells how much profit the company generates for its equity holders. The higher the ratio, the more profit the company generates for its equity holders or investors. For example, Starbucks has a ROE of around 56% which means it generates 0.56 cents for every $1 invested by its shareholders, signaling exceptional returns.

Historically, companies with higher ROE have performed better than companies with lower ROE.

ROE = Net Profit / Shareholders’ Equity

An adjusted version is the following (Return on Average Equity)

ROAE = Net Profit / Average Equity

Average equity is an adjusted version and is calculated by adding the value of the equity at the beginning of the period to its value at the end of the period then dividing the sum by two.

EBIT Margin (Operating Margin)

EBIT stands for Earnings before Interest and Taxes. EBIT is attributable to both debt and equity investors. Sometimes the company has a very high EBIT margin or profit but very low net profits since it has to pay a very high interest payments to debt holders of the company. In such case, the company may need to consider its high financing costs.

Consider, for example, Avon Products which has an operating margin of 4.4% but negative net profit margins or net profits due to very high interest payout. Similarly, companies with high depreciation expense or a large asset base should be compared based on EBITDA (Earnings before interest, depreciation and amortization) margins. Depreciation expenses refer to payments of the cost of durable assets and equipment of the firm (buildings for example, or heavy machinery) throughout the lifetime of the asset. For example, a machine that costs 200,000 USD and a lifetime of 5 years and 0 junk value has 5 depreciation payments in the amount of 40,000 USD each. Every year 40,000 is paid until the end of the lifetime of the asset in 5 years.

EBIT Margin = EBIT / Net Revenue

EBITDA Margin = EBITDA / Net Revenue

Net Margin

Net margin shows how much profit the company generates for its equity investors. Since net profit belongs to equity investors it is very important for the company to show constant net profits and increasing margins. Net margin depicts what percent of revenues are converted into profits of the company. For example, net margin of 10% means company generated $10 of profits for every$100 of revenue.

Valuation Ratios

Price Earnings Ratio (PE Ratio)

Price to earnings ratio is commonly used as a valuation metric. It fits well with most of the industries except for banks, since they tend to have high investment in loans and their PE ratios tend to be low as a result of their risk exposure. Price to earnings compares the market price of a share to the earnings of the company. The higher the earnings per share, the higher the share price of the company. Earnings per share (EPS) refer to to the proportion of net income allocated to each common share, and is calculated as follows:

EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares

Price to earnings denotes how much time the company will take to reach its stock price. If company’s PE ratio is 20 then it means based on current earnings company will take 20 years to earn its stock price. The lower the ratio in comparison to its peers, the cheaper the stock is.

PE = Market price of share / Earnings per share

Price to Earnings Growth Ratio (PEG)

To overcome the short coming of PE ratio, PEG ratio is often used by analysts. Some companies or industries trade at a very high PE which makes it difficult to make a decision. To overcome that problem, growth rate of earnings is given importance. Consider the case of Company A and Company B trading at a PE of 30, but company A grew its last year EPS by 5% but Company B, EPS grew by 30%, leading to lower PEG ratio of Company B. Company A’s PEG ratio will be (30/5 = 6x) whereas company B’s PEG ratio will be at (30/30 = 1x). According to PE ratio both companies were on par but according to PEG ratio company B looks a lot cheaper than Company A.

PEG ratio = PE ratio / EPS growth %

Price to Book Ratio (P/B)

Price to book ratio is also a very commonly used valuation metric. It is mostly used for banks or non banking financial institutions (NBFC) since their balance sheet is kept at market price. It compares the price of a share to the book value of the share. The lower the ratio, the stronger the stock looks.

PB = Market price of share / Book value per share

Price to Sales Ratio (P/S)

Price to sales ratio refers to the price you are paying for the company based on the sales per share done by the company. It is mostly used for the companies which are in their initial stages of business or lack operational or net profits. They are valued based on their revenue, providing higher value to the company with higher sales (or Revenue). For a newly commenced e-commerce company, the lack of profits due to competition makes P/S a better ratio to analyze. The company can be valued based on its revenue and it is assumed that player with higher revenue will become a more established player in the future.

Price to Sales = Price per share / Sales per share

Dividend Yield

Dividend yield is the percentage of dividend received by shareholder in comparison to market price of a stock. For example, if Company A pays $1 as dividend and market price of its share is$20 then its dividend yield will be 5%.

Dividend Yield = Dividend per share / Market price of share

Dividend Payout Ratio

Dividend payout ratio is the amount of dividends paid by the company in comparison to net profits earned. For example, if a company earns $100 and pays$50 as dividends then its dividend payout ratio is 50%. Similarly, the reverse of dividend payout ratio is retention ratio (percentage of profits retained by the company ).

Dividend Payout Ratio = Total Dividends Paid / Net Profits

Retention Ratio = 1 - Dividend payout ratio

Note – Dividend payout ratio compares dividends to net profits whereas dividend yield compares dividends to the market price of the share.

Solvency Ratio

Debt to Equity Ratio

It is used to measure the proportion of debt the company has in comparison to equity. The higher the portion of debt in comparison to equity, the higher the uncertainty about a company’s future. Companies with higher level of debt are more risky than companies with lower levels of debt. A high level of debt in comparison to equity indicates that company is more dependent on debt financing. Some companies also have negative level of equity but very high levels of debt making them very risky in nature. A negative level of equity simply means that the total liabilities are bigger than the total assets (Assets = liabilities + equity). In such case, the stockholders would theoretically owe money to the firm instead of the other way around. However, in limited liability companies, stockholders are protected in that regards from any claims.

Shareholders’ equity = assets - liability.

When the liabilities exceed the value of the assets the company will show negative shareholder’s equity on its balance sheet. This signifies a critical performance problem that the company has.

Consider, for example, Avon Products which has a negative equity but very high levels of debt, due to constant losses and a high interest expense. Debt to equity equal to or less than 1 is considered healthy but anything significantly above that is not sustainable in long run.

Debt to Equity = Total Debt / Total Equity

Interest Coverage Ratio

It is used to assess a company’s ability to make its interest payments. The higher the earnings of the company before interest in comparison to interest paid, the better the interest coverage. Since earnings before interest and taxes (EBIT) belongs to both debt and equity and excludes amount of interest paid, it is the right value to measure interest coverage. Companies with an interest coverage more than 1 can easily pay interest payments but above 2 times (2x) is considered to be safe.

Interest coverage = Earnings before interest and taxes (EBIT) / Interest Paid

Efficiency Ratios

Asset Turnover

The ratio shows how efficiently the business uses its assets to generate sales. It is mainly used to differentiate firms which can generate very high sales by employing fewer assets. For example, Company A and B operates in same business and have $100 of sales but Company A had an average assets of$50 whereas company B had an average assets of $100. This will lead to better asset turnover for Company A (2x) compared with 1x for Company B. It means company A allocates its resource more efficiently than Company B.

Asset Turnover = Sales / Average total Assets

Average total assets is calculated by adding the value of the assets at the beginning of the period to the value of assets at the end of the period and then dividing the sum by two.

Inventory Turnover

It measures how efficiently the company manages its inventories. A higher inventory turnover indicates more efficient inventory management by the firm. It measures that how many times the inventory is converted into sales over a period of time or how fast the company is selling its inventory.

Inventory is compared with cost of goods sold (COGS) because it includes the cost of actual stock whereas sales include profit margin which does not make it a suitable parameter for comparison. Very high levels of inventory turnover can be the result of result of large discounts so they should be seen with skepticism.

Inventory Turnover = COGS / Average Inventory

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