When considering an investment in the stock market it is important to learn as much about that company and the industry as possible. You’ll want to read company reports, announcements, and ask as many questions as possible that might uncover any red flags. Our Ultimate Value Investing Checklist may help with this.
But sometimes you might just need to quickly check if the company is in a good spot and worth doing some extra research on. This can be done by looking over the financial statements and commentary, but I find that management typically has a tendency to highlight to the market the positive news while burying the negative news towards the back.
These 20 value investing ratios are quick to calculate and will give you a rough idea on how the business is tracking this year. This article is broken down into four sections: Profitability ratios, Balance Sheet strength, Cash Flow ratios, and Valuation Ratios.
Return on Equity
NPAT / Shareholders Equity
ROE tells you how much money the company was able to generate from the current investment in the company from shareholders. ROE is expressed as a percentage and the higher the better.
Return on Assets
NPAT / Total Assets
Similar to ROE, Return on assets measures how much money was able to be earned from the amount invested in assets. Stated another way, how profitable are the assets that the company owns?
Net Profit Margin
NPAT / Revenue
Net Profit Margin measures how much revenue was able to be retained after all expenses and other outgoings. This will vary significantly between industries so should really only be used to compare the company with its prior years’ performance, or to compare the company with industry peers.
Gross Profit Margin
Gross Profit Margin / Revenue
Gross Profit Margin, also known as net revenue, is how much money the company has received after taking into account the cost of goods sold. Gross Profit Margin is the top line result and is the figure that all other overhead expenses are taken from. Similar to Net Profit Margin, Gross Profit Margin will vary across industries.
Balance Sheet Strength
Current Assets / Current Liabilities
The Current Ratio measures the short term liquidity requirements of the company by comparing Current Assets to Current Liabilities. If a company has significantly more Current Liabilities (i.e. due in the next 12 months) than Current Assets (i.e. cash or accounts due in the next 12 months), then they may struggle to meet their short term financial obligations.
Interest Coverage Ratio
EBIT / Interest Expense
Interest Coverage Ratio measures the ability of the company to meet its interest obligations year-on-year. If a company has unsustainably high debt then this will be a very low number. Ideally, investors want interest to be a small percentage of EBIT.
Debt Coverage Ratio
(Short term + long term debt) / EBIT
Debt Coverage Ratio measures the company’s ability to repay their debt from EBIT in the medium term. Even though they may not, investors want the company to have the ability to repay the debt in the next five years. (I.e. Debt Coverage Ratio < 5).
Debt to Equity Ratio
Liabilities / Total Equity
Debt to Equity Ratio is a simple measure of how the company is primarily financed. If the Debt/Equity Ratio is high, it means the company has been growing aggressively by taking on debt and therefore might have a higher risk attached to it, because if the earnings expected from any additional debt do not flow through, the company may be in danger of default.
COGS / Average Total Inventory
Inventory Turnover estimates how many times through the year the company was able to cycle through its inventory. By taking the total amount spent on inventory (COGS) throughout the year investors are given a rough indication of the cycle by dividing it by the average inventory for the current and prior year.
A higher number is favourable because it means inventory is being turned over regularly, it is not costing the company money by sitting stagnant, and there is a lower risk of an inventory value write down due to obsolete stock.
Days Inventory Ratio
(Inventory / COGS) x 365
The Days Inventory Ratio measures how many days it takes the company to churn its inventory. In other words, how long does the company have possession of the inventory before being sold?
Accounts Receivable Turnover
Revenue / Average Total Accounts Receivable
In a similar manner to the Inventory Turnover, the Accounts Receivable Turnover measures how many times the company cycles through accounts receivable accounts. A higher number is favourable because this indicates that accounts are being paid quicker.
Days Sales Outstanding
(Accounts Receivable / Revenue) x 365
Days Sales Outstanding measures, in days, how long it takes the company to receive the cash from sales made on credit.
Revenue / Average Total Assets
A similar ratio to Return on Assets in principle, asset turnover measures how much revenue is earned on asset investments. A ratio of 1.0 means that the company earned $1 in revenue, for every dollar invested in assets.
Cash Flow Ratios
Cash Conversion Ratio
Operating Cash Flow / NPAT
Cash Conversion Ratio measures how efficiently the company can convert receivables into cash. If Cash Conversion is low, it essentially means that cash received from customers was too low in comparison to cash paid to suppliers. If this continues for too many successive years the company will have cash flow problems, and even though revenue may have been recognized, the actual cash may never have eventually been received.
Cash Conversion should average above 100% over a number of years.
Free Cash Flow
Operating Cash Flow – Tax – Interest – Capex
Free Cash Flow is not a ratio as such, but does disclose the amount of cash the company has to fund its daily activities after tax, interest and capital expenditure are taken into account.
Price to Earnings Ratio (P/E)
Today’s Price / EPS
Price to earnings is also referred as the multiple the company is trading on. It essentially tells investors for every dollar you pay for a share in the company, how many years it will take for the company to earn that back in earnings.
P/E Ratio / (EPS Growth x 100)
The PEG Ratio is useful for analysing high growth companies as it can give context to a high P/E. By comparing the P/E to the EPS growth rate we can somewhat rationalize the high multiple paid due to high growth.
A PEG of around 1.0 is considered acceptable. Too much higher and the growth does not warrant such a high P/E.
Price to Book Value
Market Cap / (Shareholders Equity – Intangibles)
Book Value is the value of the company based on the net assets (or total equity) on the balance sheet. By dividing the market cap by the Shareholders Equity we get a price multiple of the net assets per share, which theoretically represents the liquidation value of the company per share.
Intangibles are excluded from the calculation because intangible assets generally do not have a resale value. Goodwill is one such example.
Dividend Per Share / Current Price
This simple calculation displays the return from dividends as a percentage of the amount invested.
Per Share / Current Price
In a similar manner to the Dividend Yield, the Earnings Yield calculates the return from Earnings Per Share as a percentage of the amount invested.
As with any investment, care needs to be taken to ensure that you understand the investment completely before committing any money. Part of that involves understanding the business model and growth prospects of the company, and part of it evaluating the robustness of the financials.
Use these 20 ratios to help you quickly analyse if a business is worth researching deeper.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation and needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.