Stock picking is not an easy science or art, though it is not rocket science either. It requires methodical calculations and analysis. Some of the calculations are simple while some are more involving. Professional analysts undertake their stock-picking by estimating the intrinsic value of a company of interest. Estimating the intrinsic value entails forecasting a company’s sales, costs, earnings and financial conditions, among others.
Equipped with the intrinsic value of a company, an analyst can identify if a stock is overvalued, undervalued, or fairly valued in relation to their current market value. It is this relationship between the estimated intrinsic value and the current market price that informs a buy, sell or hold decision.
Though the professional analysts, who make a living from financial analysis and stock picking and trading use a wide range of robust analysis or algorithms and engage in painstaking and time-consuming research, there are a few basic financial ratios that the not too sophisticated lay stock market investor can use in making investment decisions. Just like financial statements come in sub-reports, financial statement analysis by way of ratio analysis follows each of the subreports. Here are some of them.
Profitability ratios track the financial performance of a company over a period of time. Among the profitability ratios that analysts use include, gross profit margin, operating margin, net profit margin, return on assets employed, return on equity, and earnings per share, among others. Gross margin measures the margin available to cover a company’s operating expenses. It is measured as gross profit divided by net sales and expressed in percentage terms. On the other hand, operating margin measures a company’s profitability from the main business of the company.
It is measured as operating profit divided by net sales expressed in percentage terms. Net profit margin measures the same profitability after accounting for taxes. It is measured as net profit after taxes divided by net sales. Return on equity measures the return on investments made by shareholders through their equity holdings in a company. It is measured as net income after taxes divided by total owners’ equity. Return on assets is a measure of the return to shareholders and creditors of a company. It is measured as net income after taxes divided by total assets of a company.
These ratios measure the extent to which a company’s cash or short-term assets are able to cover its current or short-term liabilities. While current assets are expected to outweigh current liabilities, a liquidity ratio that is too high could signify that a company is not utilizing its current assets well and may be sacrificing profitability. When liquidity ratio is too low, it is an indication that a company may not be able to meet its short-term financial obligations when due. So, investors and analysts look for a middle-of-the-road liquidity ratio. The liquidity ratios that are in use include current ratio, quick ratio, and working capital.
The current ratio as a liquidity ratio measures the ability of a company to pay back its current or short-term liabilities. The higher the ratio, the higher the ability of a company to meet its short-term debt obligations. It is calculated as Current Assets divided by Current Liabilities. The information or data for this calculation is obtainable from the current asset/liability section of the balance sheet of a company.
The quick ratio, otherwise known as acid test ratio, is very much like the current ratio and measures basically the same thing. However, certain current assets that may not be easily realizable in cash, such as inventory, that are included in the calculation of current ratio, are excluded from quick ratio calculation. Like current ratio, a higher quick ratio indicates a higher ability of a company to meet its short-term financial liabilities. The quick ratio is calculated as (Current Assets less Inventory) divided by current liabilities.
Working capital is current assets minus current liabilities. It measures the extent to which current resources of a company exceed its current financial obligations. The greater the number, the greater the comfort level that a company has to meet any unforeseen cash requirements.
Solvency ratios are those ratios that reflect a company’s ability to meet its financial long-term obligations. It also points to how a company finances its operations. Again, a middle-of-the-road ratio is desirable, as too high solvency ratio portends a company that may be struggling with meeting its long-term financial obligations, while too low solvency ratio could indicate a company that is not taking advantage of long-term borrowing opportunities. Among solvency ratios that analysts use, include debt to assets, debt to equity, long term debt to equity and interest coverage ratios.
Debt to Equity Ratio is a ratio that indicates how much a company is in debt in relation to the stake that shareholders have in the company, otherwise called shareholders’ equity. The higher the ratio, the worse the situation. The ratio is calculated as Total Liabilities divided by Shareholders Equity. The information on the total liabilities and shareholders’ equity are readily available from a company’s financial statements, notably, the balance sheet.
Debt to Asset Ratio
This ratio measures the extent to which a company borrows money to finance its operations. It is calculated as total debt divided by total assets. The higher the ratio, the worse the financial state of a company.
Interest coverage ratio measures the extent to which operating profit exceeds the fixed interest expenses that a company must pay. The higher the ratio, the less the likelihood that the company would be unable to meet its fixed interest expense when due.
Using Financial Ratios
Financial ratios are not just calculated for the fun of it. They are used to compare a company’s current performance with its prior years’ performance to know if its financial circumstances are improving, deteriorating, or the same. They are used to also compare similar companies (peer comparison) so as to know which to invest in.
[READ ALSO: Don’t get stuck buying these stocks]
Limitations of Financial Ratios
Financial ratios are not perfect; they are only surrogates to the real numbers and should, therefore, be interpreted and used as such. Financial ratios are based on numbers from the financial statement, such that, where the financial statement is doctored or window dressed, the resulting ratios will follow suit. However, analysts have designed ways and means to uncover financial shenanigans when analyzing financial ratios. In my next article on this topic, I will take a look at how to watch for and detect financial shenanigans.