09 Jun 8 Key Financial Ratios That Value Investors Absolutely Must Know
Value Investing is nothing fanciful. The problem is that there are too many financial ratios to confuse the investors. The key is to look at the right ones. Study enough to make an informed decision to buy and sell. There is no point listening to too many opinions or over-analyse a company and end up taking no action because the signals are contradicting one another. To help you, I have list down 8 key financial ratios that you, as a value investor, must know.
#1 – Price-Earnings
PE ratio is the most common financial ratio to investors. The numerator is the price of the stocks while the denominator is the earnings of the company. This means that how many times of earnings are you paying for the stocks. For example, if the PE is 10, it means that you are paying 10 years worth of earnings. The lower the PE, the better. Let’s use an example to illustrate this. You saw a house selling for $1m and the owner said it is tenanted. The owner tells you the rental is worth $5k a month. After you have factored all the costs in owning and maintaining the house, your net profit is $2k a month or $24k a year. So the PE ratio for the house will be about 42. It will take 42 years for you to get back the worth of the house through a positive cashflow of $2k per month.
Although PE is a favourite ratio, it is ever changing. Firstly, price can change. No one can predict how high the stock prices can go and although the PE can be high in your opinion, it can continue to go higher beyond your imagination. The other factor that causes PE to change is the significant rise and fall in earnings. A company can be making a lot of money for the past 10 years but because of competition, they may lose market share and suffer a decline in earnings. Hence, PE ratio is at best a view of the company’s and its stock’s historical performance. It does not tell you the future. You would need to assess the quality aspect of the company – Can it sustain it’s earnings? Will the earnings grow?
#2 – Price / Free Cash Flow(FCF)
There is a belief 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, which the statement shows the movement of money in and out of the company. FCF is defined as, Cash Flow from Operations – Capital Expenditures. If the number is positive, it tells us that the company is taking in more money than it is spending. And it often indicates a rise in earnings. PE and P/FCF should tell the same story. You can use either or use both to detect any anomaly/divergence.
#3 – Price Earnings Growth Rate (PEG)
We recognise the deficiency of PE ratio which is plainly historical performance. Is there a better way to look into the future to get a sense if the company is a good buy? The house example assumed the rental does not grow over time. But you and I know that it is not totally true. Rental may go up due to inflation. Likewise, growing companies are likely to increase their earnings in the future. One of the ways to factor this growth is to look at PEG ratio. It is simply PE / Annual Earnings Per Share (EPS) Growth Rate. Yes, it is a mouthful. I will explain the denominator. EPS is simply earnings divided by the number of shares. But we need to look at the growth of earnings. So we have to average out the growth in EPS for the past few years. For example, 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, PEG ratio less than 1 is deem 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. Warren Buffett is smart in this area because he buys into companies with competitive advantage. Only this way, he can be more certain that the earnings will continue to grow, or at least remain the same.
#4 – Price-to-Book or Price-to-Net Asset Value
PB ratio is the second most common ratio. Some people call it price to net asset value (NAV) instead. Net asset is the difference between the value of the TANGIBLE assets the company possessed and the liability the company assumed (intangible assets like goodwill which should be excluded). Let’s revisit the house example. Your house is worth $1m dollars and you owe the bank $500k, so your net asset value of the house is $500k. 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 net asset of the company – think along the lines that you can buy a house below market value.
There is a word of caution when you look 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 asset of the company. The worst assets to hold are products with expiry, like agricultural crops etc. Also, during property booms, the assets may go up significantly as the properties are revalued. The NAV may tank if the property market crashes.
#5 – Debt-to-Asset or Debt-to-Equity
Sometimes I wondered if I should be looking at Debt-to-Asset (D/A) or Debt-to-Equity (D/E) ratios. After a while, I realised either one of them is fine because both are just trying to measure the debt level of the company. Most importantly, use the same metric to make comparisons. Do not compare a stock’s D/A with another stocks’s D/E! Let’s go back to the example of your $1m house and remember you still owe the bank $500k, what would your D/A and D/E look like? Your D/A will follow the formula, Total Liabilities / Total Assets, which will give you a value of 50% in this case (assuming you only have this house and no other assets or liabilities for the sake of this example). Your D/E, which is defined as Total Liabilities / Net Asset Value, will give you a value of 100%. Hence, for D/A at 50%, it should mean something like this to you: 50% of my house is serviced through debt. And for D/E at 100%, you should read it as: if I sell my house now, I can repay 100% of the debt without having to top up.
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 debts the company is assuming. The company may be earning record profits but the performance may largely be supported by leverage. 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 the 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. Current Ratio is simply Current Assets / Current Liabilities. ‘Current’ in accounting means less than 1 year. Current assets are examples like cash and fixed deposits. Current liabilities are loans that are due within one year. Quick Ratio is, Current Assets – Inventory / 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 company 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 company’s usage. Payout ratio is to measure the percentage of earnings given out as dividends. You will understand how much the company is keeping the earnings and you should ask the management what do they intend to do with the money. Are they expanding the business geographically or production capacity? Are they acquiring other businesses? Or are they just keeping the money without having knowing what to do with it? 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 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. 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 humans are selfish to a certain extent and if you have the CEO/Chairman having more stake in the company, you are certain he will look after you (and himself).
Where to find these ratios?
You do not need to calculate all these values yourself! There are websites which have done the service for us. Some are free and some are paid. My advice is try the free ones first and if it is not sufficient, then pay for more information. The following are some of the sites you can consider:
There you go. 8 Key Financial Ratios in a nutshell and some websites for your reference. Let me know what other websites provide such fundamental data. Share the good stuffs with us!
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