By Alvin Chow (guest contributor)
Value Investing is nothing fanciful. The issue, however, is the abundance of financial ratios that confuse the investors. The key is to look at the right ones, and study enough to make an informed decision to buy and sell. Listening to too many opinions or over-analyzing a company without taking action is pointless because the signals will contradict one another. To assist you, I have listed down eight crucial financial ratios that a financial investor must know.
#1 – Price to Earnings
PE ratio is the most common financial ratio to investors. The numerator of the ratio would be the stock price whilst the denominator would be the company’s earnings. This represents the numbers of times of earnings one pays for the stocks. For example, assuming the PE is 10, this translates to a payment of 10 years worth of earnings. Hence, the lower the PE, the better.
Let’s use another example to illustrate this. A tenanted house is selling for $1 million with a monthly rental of $5,000. After factoring all the maintenance costs of owning the house, your net profit is $2,000 a month or $24,000 a year. By dividing the total cost of the house by net profit, we find that the PE ratio of the house will be approximately 42. Hence, it will take 42 years to regain the worth of the house through a monthly positive cashflow of $2,000.
Although PE ratio is a hot favorite, it is very volatile in nature with regards to prices and earnings. Firstly, no one can predict how high stock prices can go, as although the PE may seem very large to the individual, it may continue to rise further to unimaginable heights.
Secondly, the significant rise and fall in earnings causes the PE ratio to change. For instance, a company making a lot of profit in the past decade might lose market share and suffer a decline in earnings due to increased competition. In this case therefore, PE ratio is, at best, a view of the company’s and its stock’s historical performance. It does not tell you the future. In order to do that, one would have to assess the quality aspect of the company by considering: Is it or is it not able to sustain and increase earnings?
#2 – Price to Free Cash Flow (FCF)
There is a belief which states that while it is possible to fake the income statement, it is harder to fake cash flow. Hence, besides looking at the PE ratio, you can examine the P/FCF Ratio.
FCF is calculated based on the values from the cash flow statement, where the statement shows the movement of money in and out of the company. FCF is defined as Cash Flow from Operations minus Capital Expenditures.
To interpret Cash Flow, we observe if the number is positive or not. A positive number tells us that the company has more cash earnings than expenditures. PE and P/FCF should tell the same story. Hence, you can use either or both to detect any anomaly/divergence.
#3 – Price Earnings to Growth Rate (PEG)
Is there a better way to look into the future for a sense if a particular company is a good buy? The house example before assumed the rental does not grow over time. However, both you and I know that it is not totally true. Rental may rise due to inflation. Likewise, growing companies are likely to increase their earnings in the future. Hence, one of the ways to factor this growth is to consider the PEG ratio.
The PEG ratio is simply the PE divided by the Annual Earnings Per Share (EPS) Growth Rate. Yes, it is a mouthful. First, let me explain the denominator. EPS is earnings divided by the number of shares. But it does not end there yet as we still need to look at the growth of earnings. To do that, we have to average out the growth in EPS for the past few years.
Let’s look at an example to illustrate this better. If the company has been growing at a rate of 10% per year, and its PE is 10, the PEG would be 1. In general, a PEG ratio of less than 1 is deemed as undervalued. However, it is important to understand that we are assuming the company would continue to grow at this rate. No one can forecast earnings accurately.
Hence, Warren Buffett is smart in this area because he buys into companies with a competitive advantage. It is only in this way that he can be more certain the earnings will continue to grow, or at least remain constant.
#4 – Price-to-Book Ratio (PB) or Price-to-Net Asset Value (PNAV)
PB ratio is the second most common ratio. Some people call it price to net asset value (PNAV) instead. Net assets are the difference between the value of the tangible assets the company possesses and the liability the company assumes (intangible assets like goodwill should be excluded).
Let’s revisit the house example. Your house is worth $1 million dollars and hypothetically you owe the bank $500,000. Your net asset value of the house will be $500,000. Hence, the higher the net asset value, the better. If the stock’s PB ratio is less than 1, it means that you are paying less than the net assets of the company – assuming that you can buy a house below market value.
However, a word of caution when looking at NAV. These numbers are what the companies report and they may overstate or understate the value of assets and liabilities. In fact, not all assets are equal. For example, a piece of real estate is more precious than product inventory. Rising inventory is a sign the company is not making sales and earnings may drop. Hence, rising assets or NAV may not always be a good thing. You have to assess the assets of the company. The worst resources to hold are products with expiry, like agricultural crops etc. Also, during property booms, these assets may go up significantly as the properties are revalued. Hence, the NAV may fall if the property market crashes.
#5 – Debt-to-Asset or Debt-to-Equity
Back in the day, I used to wonder if I should be looking at Debt-to-Assets (D/A) or Debt-to-Equity (D/E) ratios. After a while, I realized that either is fine because both are simply trying to measure the debt level of the company. What is more important however, is using the same metric to make comparisons. Never compare a stock’s D/A with another stocks’ D/E!
Again, we can use the example of your $1 million house and debt of $500,000 to the bank to illustrate this. What would your D/A and D/E look like in this case? Your D/A will follow the formula Total Debt divided by Total Assets. This gives you a value of 50% (assuming you only have this house and no other assets or liabilities for the sake of this example). Your D/E, defined as Total Debt / Net Asset Value, will give a value of 100%.
As you can see, it is just a matter of preference and there is no difference to which ratio you should use. Most importantly, the value of D/A or D/E is to understand how much debt the company is assuming. The company may be earning record profits but the performance may largely be supported by leverage. Furthermore, you should not be happy to see D/A and D/E rising. Leveraged performance is impressive during the good times but during bad times, companies run the risk of bankruptcy.
#6 – Current Ratio or Quick Ratio
Long term debts usually take up the majority of total liabilities. Although the company may have a manageable long-term debt level, it may not have sufficient liquidity to meet short term debts. This is important as cash in the short term is the lifeline of a business.
One way to assess this is to look at the Current Ratio or Quick Ratio. Again, it does not really matter which one you are looking at. In investing and in life, nothing is 100% accurate. Close enough is good enough. The equation for Current Ratio would be the Current Assets divided by Current Liabilities. ‘Current’ in accounting means less than 1 year. Current assets are examples like cash and fixed deposits whilst current liabilities are loans that are due within one year.
Next, the formula for the Quick ratio would be (Current Assets – Inventory) divided by Current Liabilities, and it is slightly more stringent than Current ratio. Quick ratio is more apt for companies that sell products where inventory can take up a large part of their assets. It does not make a difference to companies selling a service.
#7 – Payout Ratio
A company can do two things to their earnings: (1) distribute dividends to shareholders and/or (2) retain earnings for the company’s usage. The payout ratio is used to measure the percentage of earnings given out as dividends, and to help you understand how much earnings the company keeps and how they intend to spend. Questions such as “Are they expanding the business geographically or the production capacity? Are they acquiring other businesses? Or are they just keeping the money without knowing what to do with it?” would be good to consider. There is nothing wrong for the company to retain earnings if the management is going to make good use of the money. Otherwise, they should give out a higher percentage of dividends to shareholders. This is a good ratio to question the management on and judge if they really care about the shareholders.
#8 – Management Ownership Percentage
This is not a financial ratio per se but it is important to look at. It is unlikely the CEO or Chairman would own more than 50% of a large corporation. Hence, this is more applicable to small companies. Personally, I like to buy into small and profitable companies where their CEO/Chairman is a majority shareholder. This is to ensure his interests are aligned to the shareholders. It is natural that humans are selfish to a certain extent and if the CEO/Chairman has a higher stake in the company, you can be certain he will look after you (and himself).
Where to find these ratios?
With the host of equations and ratios earlier, it must appear a chore to do all these calculations. However, you do not need to calculate all these values yourself! There are websites that have it for us. Some are free and some require payment. My advice is to try the free ones first and if it is not sufficient, then you can consider paying for more information. The following are some of the sites I would recommend.
There you go. 8 Key Financial Ratios in a nutshell and some websites for your reference. Do let me know if you are familiar with any other websites that provide such fundamental data!
By guest contributor Alvin Chow, who blogs at Big Fat Purse, a Singapore personal finance blog.