Learn how to analyze stocks like a pro

Ever wonder how the stock market gurus come up with their stock picks? Stock analysts don’t use a Magic 8 Ball, consult with psychics, or letter combinations from their Alpha Bits cereal to pick stocks.  Not that what they do isn’t a little arcane, they divine the future price of stocks by rearranging different number combinations related to the performance of companies.  These number combinations are financial ratios and something you’ll fully understand once you’ve read this series of articles.  By using these ratios yourself you’ll be better able to make your own stock purchase decisions and minimize your risk, just like the pros.

Financial ratios provide a useful way of identifying a company’s performance and value when compared to industry averages.  When combined they can paint an overall picture of how well a company is doing compared to its competition and whether or not it’s a good investment.  All the information needed to calculate financial ratios can be found in a company’s financial statement.

There are six categories of financial ratios:

• Liquidity ratios which measure a company’s ability to pay its bills when they come due;
• Asset management ratios which measure how effectively the firm is managing its assets;
• Debt management ratios which show how much a firm uses debt financing (also called financial leverage);
• Profitability ratios which measure how successful a company is at making a profit during a current year;
• Market value ratios compare the company’s stock price to its earnings, cash flow, and book value per share.  They give an indication of what investors think of a company’s past performance and future prospects; and
• Effectiveness ratios which measure the effectiveness with which a company is utilizing its assets.

Liquidity Ratios:

Current ratio = current assets / current liabilities

The current ratio is the most commonly used measure of short-term solvency.  Current assets normally include cash, marketable securities, accounts receivable, and inventories.  Current liabilities are accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses.

• A low current ratio shows assets are working to grow the business.
• Creditors like to see a high current ratio because it reduces risk.

Quick ratio = current assets – inventory / current liabilities

Inventories are usually the least liquid of a company’s assets so in the event the company goes bankrupt this is where most of the losses will come from.  Large inventories may make the company seem less liquid to investors and creditors and therefore a credit risk.

Asset Management Ratios:

Inventory turnover rate = sales / inventories

Turnover is the rate a company has to replace its inventory.  The term turnover originated with the old Yankee peddler who would fill his wagon with goods to be sold and go on the road to sell his wares and “turnover” was the number of times he had to go back for more merchandise.  A turnover rate lower than the industry average would be an indication the company is holding too much inventory.

Days Sales Outstanding = Receivables / Average sales per day = Receivables / Annual sales/365 days

Days sales outstanding (DSO, also called “average collection period”) is used to the number of days’ sales tied up in accounts receivable, or the average length of time a company has to wait after making a sale before receiving cash.  If the DSO is higher than the industry average or if this number is rising over time it means the company is being deprived of money it could be putting to better use.

Fixed Assets Turnover Ratio = Sales / Net fixed assets

The fixed assets turnover ratio measures how well a company uses its plant and equipment and should be compared to the industry average to get an idea of well the business is doing.  This ratio should be equal to or greater than the industry average.

Total Assets Turnover Ratio =  Sales / Total assets

The total assets turnover ratio is a measure of the turnover of all the company’s assets.  If this number is below the industry average it would be an indication the company is not generating enough business compared to its total asset investment.

Debt Management Ratios:

Times-Interest-Earned (TIE ) Ratio = Earnings Before Income Tax (EBIT) / Interest charges

The times-interest-earned (TIE) ratio provides a measure of how much operating income can decline before the company can’t meet its annual interest costs.  If this number is lower than the industry average it would indicate the company could run into difficulties if it attempted to borrow more money.

EBITDA Coverage Ratio = EBITDA + Lease payments / Interest + Principal payments + Lease payments

The TIE ratio is a measure of a company’s ability to pay interest on its debts, but interest isn’t the only financial charge.  The EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) coverage ratio is an indication of a company’s ability to satisfy all its financial obligations including leases and principal payments.

Profitability Ratios:

Profit Margin on Sales = Net income available to common stockholders / Sales

Profit margin on sales gives the profit per dollar of sales.  If this ratio is lower than the industry average it would indicate the company costs are too high, they have too much debt, or some combination of the two.

Basic Earning Power (BEP) = EBIT / Total assets

This ratio shows the raw earnings power of a company’s assets before taking taxes into consideration.  This is a good tool for comparing companies with different tax situations and different degrees of financial leverage.  A company’s BEP should be equal to or greater than the industry average.

Return on Total Assets (ROA) = Net income available to common stockholders / Total assets

Return on Total Assets is the ratio of net income to total assets.  ROA shows how well a company is using its assets to generate earnings before contractual obligations have to be paid.

Return on Common Equity = Net income available to common stockholders / Common equity

Return on equity shows how much profit a company makes with the money shareholders have invested.  Common equity refers to common stockholders’ equity, not that of preferred stockholders.

Market Value Ratios:

Price / Earnings (P/E) Ratio = Price per share / Earnings per share

The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported profits.  P/E ratios are higher for firms with strong growth prospects and lower for riskier firms.

Price/Cash Flow Ratio = Price per share / Cash flow per share

In some industries the stock price is affected by cash flow more than net income so investors will use this ratio rather than the P/E ratio.  This is a measure of a company’s relative value and the market’s expectations of its future financial health.  Since the price/cash flow ratio deals with cash flow the effects of depreciation and other non-cash factors aren’t used.

Book value per share = Common equity / Shares outstanding

Book value is the accounting value of each share, which is different from how the market values a stock.  Market value is what investors value the stock at and book value is based on costs and retained earnings. One situation where this would be useful is if the market value is trading below the book value, in which case this would mean that the company is undervalued and a good buy.

Market/book (M/B) ratio = Market price per share / Book value per share

Market/book (M/B) ratio shows the value of a company by comparing a company’s book value to its market value. Book value is calculated by looking at the firm’s historical cost, or accounting value. Market value is based on the total dollar market value of all of a company’s outstanding shares.  Market capitalization (market cap) is calculated by multiplying a company’s shares outstanding by the current market price of one share. This is how investors determine a company’s relative size, rather than using sales or total asset numbers.

In future articles I’ll explain some of the more important ratios in greater detail and we’ll cover technical analysis.

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You might also like to read:

1. How to analyze stocks like a pro – part 2
2. How to analyze stocks like a pro – part 4
3. How to analyze stocks like a pro – part 5
4. How to analyze stocks like a pro – part 3
5. 6 stocks for this economy