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2. John DoboszForbes Staff
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I cover moneyand investing.full bio →
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Florsheim Shoe Stock Polished And Ready To Run
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Nam Tai Electronics Looks Too Good To Stay This Cheap
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This Market Belongs To Stock Pickers Only
Martin SosnoffContributor
3. Simple Indicator Steers Investors Out Of U.S. Stocks, Into Treasuries
Vincent DeluardContributor
INVESTING 9/25/2013 @ 4:50PM 105,946 v iews
Ten Ratios To Make You
Money In Stocks
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Evaluating stocks to buy and sell can be a tricky business,
even with all of the data available at your fingertips. Outof
the dozens of ratios and metrics that give clues to the
financial healthof a company, a few of them are extremely
useful for their simplicity and effectiveness.
Here are ten financial ratios thatcan tell you most of what
you need to know when you’re scouring the market for
good stocks to buy.
Price-Earnings Ratio(P/E): This number tells you how
many years worth of profits you’re paying for a stock and
you calculate it by dividing the stock price by earnings per
share. All things equal, the lower the P/E the better. The
most frequently used earnings number in the calculation is
the total earnings per share over the past four reported
quarters. You could also use “forward” earnings,which is
the average of Wall Street’s forecasts for the current fiscal
year.
Benjamin Graham, the legendary investor and Warren
Buffett’s teacher at Columbia University, postulated that
stocks should trade for a P/E multiple equal to 8.5 times
earnings plus two times the growth rate of earnings.
4. Without some context, the P/E has limited value in finding
cheap stocks. For the market as a whole, the S&P 500
currently trades for 19.47 times the past 12 months of
reported earnings. The average P/E since 1935 is 15.86,
suggesting the market is a bit pricey.
Some industries like homebuilders and commodity
producers tend to trade at low P/E multiples because
earnings tumble in a hurry so investors don’t want to pay
too dearly. Rapidly growingcompanies like Netflix, with a
P/E of 382, or Facebook, trading for 222times earnings,
are valued much more on the hope of future profits that
bring the P/E down to something more modest.
For individual stocks, you should compare a stock’s P/E
with those of its competitors. It’s also usually informative
to compare the current P/E with the average multiple over
the past three-, five- or even 10 years. If it’s lower than
average, it’s a sign that you’ve spotted a possible bargain,
but that all depends on growth, which leads us into the next
ratio to watch, the PEG ratio.
New York Stock Exchange (Getty Images via @daylife)
Price/EarningsGrowth (PEG) Ratio: The PEG ratio is
another Benjamin Graham invention which attempts to
measure the degree of a discount or premium you’re paying
for growth. The calculation is to divide the P/E ratio by the
long-term annualized percentage growthrate of earnings,
ideally the next five years’ worth. A result of less than 1.0
implies that the market is not fully valuing the prospects
for future growth.
The downside of the PEG ratio is that future growth rates
are notoriously hard to predict. Companies’ growth profiles
can change, sometimes drastically. Apple is a good
5. example. It trades at a svelte 0.86 PEG ratio based on a
P/E of 12.2 and a five-year EPS growth rate of 14.5%
annualized.That’s appreciably lower than the 72% growth
rate over the past five years, but still enough, if it
materializes, to suggest that Apple buyers are getting a
bargain.
Price-to-Sales(P/S): Similar to the P/E ratio, the price-
sales ratio divides that market capitalization of a stock by
total sales over the past 12 months, instead of earnings.
Popularized by investment manager and longtime Forbes
columnist, Ken Fisher, the price-sales ratio tells you how
much you are paying for every dollar in annual sales.
Because there are times when cyclical companies have no
earnings, the price-sales multiple can be a better indicator
of a company’s relative value than the P/E. Like other
ratios, you should compare the P/S of a stock of those with
competitors and with historical sales multiples. Sales are
also more difficult to manipulate than earnings,giving a
more reliable gauge of value. Keep in mind, however, that
the beauty of a low P/S ratio can be spoiled by a constant
lack of profitability and large levels of debt.
Price/Cash Flow (P/CF): This useful measure of value is
obtained by dividing the market value by operating cash
flow over the prior 12 months. It strips out items like
amortization and depreciation from earnings and focuses
on cash generated by the business. This provides a better
way than P/E for comparing valuations of companies from
different countries that have different depreciation rules
that can affect earnings.
Lower readings are preferable but keep in mind that there
is more to cash flow than what comes from operations.
Free cash flow is what’s left over after paying down debt,
buying back stock and paying dividends. Negative free cash
flow is forgivable as long it’s not a chronic problem, but
companies that cannot produce positive cash flow from
their core business operations can face eventual liquidity
and solvency issues.
Price-To-Book Value(P/BV): This ratio tells you how
much you’re paying for every dollar of assets owned by the
company, and you calculate it by dividing the market
6. capitalization by the difference between total assets and
total liabilities. The idea is to approximate how much
money you could put your hands on if you shut down the
business and sold off everything. As with most price
multiple metrics, price-to-book is best used by comparing
present multiples to historical averages.
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The metric can be useful for comparing companies within
asset-intensive businesses but service-oriented businesses
or those without substantial property, plantand equipment
typically have little book value and trade at sky-high P/BV
multiples. For instance, United States Steel (X) trades for
0.87 times book value, while LinkedIn (LNKD) fetches an
astronomical multiple of 24.8 times book value.
Debt-to-Equity Ratio: The fundamental accounting
equation tells you that assets equal liabilities plus equity.
The debt-equity ratio is a measure of financial leverage
telling you the percentage of a company’s assets financed
by debt. The formula is to divide total debt (or just long-
term debt) by shareholder’s equity, two items both found
on the balance sheet. Off-balance sheet items like pension
obligations should also be treated as debt.
Lower numbers are generally preferred because high debt
loads can turn into big problems in a downturn. Debt cuts
both ways, however, and taking on more debt during
expansionary times gives a boost to profits. Heavy
established industries like utilities and industrials generally
have higher debt-equity ratios than rapidly growing
companies that may carry little or no debt at all. Caterpillar
has a debt-equity ratio of 2.24, while Google’s is 0.62. The
best comparisons are within industries and against a
company’s historical ratios.
Return On Equity: ROE measures a company’s
efficiency at generating profits from money invested in the
company, and it is derived by dividing by net income by
shareholder’s equity. It’s a very handy measure of
management’s effectiveness but it’s not useful for
ascertaining value of early-stage companies that do not
produce profits. For example, TeslaMotors (TSLA) has a -
115% return on equity.
7. When comparing competing investments, stocks with
higher ROE demonstrate that they can produce more profit
from each dollar of equity and, all else equal, should be
considered the superior choice.
Return On Assets: Similar to return on equity, return on
assets is a measure of management effectiveness obtained
by dividing net income by total assets. A company with a
higher ROA is usually preferable to one with a lower ROA,
since it shows the ability to grow profits more efficiently
from a given base of assets.
Companies with comparatively low ROA will need to
borrow or raise equity to achieve the same amount of
profit. ROA is most useful for intra-industry comparisons
and the trend over a multiyear period can be more
instructive than ROA for a single year or quarter.
Profit Margin: Rising sales are great but they’re not so
wonderful if they come at the expense of profit. Profit
margin shows how much a company earns from each dollar
of sales and is arrived at by dividing profit by sales. The
number you get depends on the kind of profit you choose.
Gross profit, which is sales minus cost of sales, is the
simplest measure. Operating profit is gross profit less
overhead items, and net profit (income) is what’s left after
paying taxes.
Margins vary widely by industry and tend to be highest
among manufacturers and decrease down the value chain
to wholesalers and eventually retailers. Operatingprofit
margin generally provides the best overall measure of
profitability from ongoing business activities. Be aware that
declining margins over time require higher levels of
revenue to maintain profits at current levels.
Dividend Payout Ratio: If you are looking for yield from
your equities, a fat dividend yield can appear quite
enticing, especially in a low interest rate environment. The
danger of a high yield is that it can be unsustainable, and
when it’s eventually cut, you not only lose out on the
income but the share price will often take a hit.
The dividend payout ratio is computed by dividing annual
dividends per share by earnings per share. You want this to
be less than 1.0, although real estate investment trusts,
8. master limited partnerships and business development
companies are required to pay out nearly all net income to
avoid taxation at the corporate level. It is true that earnings
include many non-cash items so you will also want to check
out the cash payout ratio, which is operating cash flowper
share divided by dividends per share. The lower the
dividend payout ratio, the greater are the chances that the
company will be able to sustain and hike the payout down
