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17 Key Financial Ratios
1. 17 Key Financial Ratios
How you can understand key attributes of any
business and quickly evaluate its investment
potential
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2. Key
attributes
of any
business
and stock
fall into 5
main
categories
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Valuation – Is the
stock an attractive
investment?
Profitability – Does
the business make
money?
Liquidity – Can the
company meet its
short term
obligations?
Business Activity –
Are the operations
efficient?
Leverage – Does the
company make
proper use of debt
and equity financing?
3. You need
to
investigate
each
group of
attributes
The proper due diligence
requires careful study of
every part of the business
An investor also concerns
himself with the valuation
metrics
Operations affect the
stock values
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5. Should
You Buy
this Stock
Today or
Not
These 6 key valuation metrics help you
look at the stock from various angles
1. Price to Earnings (P/E) Ratio
2. Price to Book (P/B) Ratio
3. Dividend Yield
4. Dividend Payout Ratio
5. Enterprise Value/EBIT (EV/EBIT)
6. PEG Ratio
6. Price to Earnings
(P/E) Ratio
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One of the primary earnings valuation metric
P/E Ratio = ( Price / Earnings per share ), or,
P/E Ratio = ( Market Value / Net Income
attributable to common stock )
It considers if you are paying a proper multiple to the
earnings of the company. You are implicitly assuming
that the company derives its market value from its
earnings power. P/E ratio should be used directionally
at best as there are many reasons why it is not a
reliable indicator of value
7. Price to Book (P/B)
Ratio
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One of the primary asset valuation metric
P/B Ratio = ( Price / Book Value per Share), or,
P/B Ratio = ( Market Value / Book Value)
It considers if you are paying a proper multiple to the
book value of the company. Book value tends to be a
more tangible and sustainable indicator of value than
the earnings power. Keep in mind that various
industries will naturally have different levels of
average or typical P/B ratios
8. Dividend Yield
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Favorite of income investors
Dividend Yield = (Annual Dividend per Share /
Current Stock Price)
Dividends provide a regular income stream to the
investors in lieu of holding the stock. This is important
to an income investor, and to investors who are
looking for an alternative to bonds
Higher dividend yields are generally better, but too
high yields may indicate a company that may not be
able to afford the dividend in the future. The next
metric helps sort out these kind of situations
9. Dividend Payout
Ratio
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Tests to see if the dividend yield is sustainable
Dividend Payout Ratio
= [ Dividends Paid / Net Income ] , or,
= [ Dividends per share / Earnings per share ]
A high dividend payout ratio indicates the company is
getting overstretched by trying to keep the dividend
going. I recommend a payout ratio of under 50%
10. Enterprise Value/EBIT
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Similar to the Price/Earnings Ratio
EV/EBIT = Enterprise Value (EV) / Earnings Before
Interest and Tax (EBIT)
You may want to use EV/EBIT if you wish a valuation
metric that is neutral to the capital structure of the
business. This is important to an acquirer as they may be
looking to re-capitalize the business, and want to get a
metric that is not distorted by the amount of debt or tax
structure, or even large amounts of cash on the books
11. P/E/G or PEG Ratio
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Tends to be some value investor’s favorite
PEG Ratio
= PE Ratio/Expected Earnings Growth Rate
Popularized by Peter Lynch, the PEG ratio tries to take
the expected earnings growth into account. The main
argument is that higher growth rates deserve a bigger
P/E multiple. A PEG ratio under 1 is considered a good
value.
14. Return on Equity
(ROE)
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How good is the company leveraging the
shareholder’s equity to make additional income
Return on Equity = Net Income/Shareholder’s
Equity
High ROE indicates that the company is able to
shepherd shareholder’s equity and generate above
average wealth for the shareholders.
15. Return on Assets
(ROA)
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How good is the company leveraging the assets it
owns?
ROA = Net Income / Total Average Assets
High ROA indicates that the company is able to make
very good use of its assets such as machinery,
property, etc.
16. Earnings per Share
(EPS)
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What are the shareholders earning per share?
Earnings Per Share (EPS) Ratio = Net
Income Attributable to the Common
Stockholders / Number of Common Shares
Outstanding
It is important to see if the EPS value trends up over
time. This implies the company is growing and
creating more income as time goes by
17. Profit Margin
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The key profitability metric
Profit Margin = Profit / Sales
This can be calculated on the gross level or on the net
level
Gross Profit Margin = (Sales – Cost of Sales)/Sales
Net Profit Margin = Net Income/Sales
19. Does the
company
have
sufficient
liquidity?
These 3 key liquidity metrics help you
understand if the company can take care
of its short term obligations
1. Current ratio
2. Quick ratio or Acid test ratio
3. Interest coverage
20. Current Ratio
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The key liquidity metric
Current Ratio = (Current Assets / Current
Liabilities)
This is used to see if the company has sufficient
current assets (assets that are quickly converted to
cash) to cover its current liabilities.
Any current ratio above 1.5 should be safe. Higher the
better.
21. Quick Ratio or Acid
Test Ratio
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Similar to Current Ratio but more stringent
Quick Ratio = (Current Assets - Inventory) /
Current Liabilities
This is used to see if the company has sufficient near
cash assets to cover its current liabilities.
22. Interest Coverage
Ratio
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Can the company pay its debt comfortably
Interest Coverage Ratio = Earnings Before Interest
and Tax / Interest Expense
You want to see an interest coverage ratio above 2.5.
An interest coverage ratio below 1 indicates
insufficient earnings to support debt payments and is
a red flag
24. Are the
operations
humming?
These 2 key operations metrics help you
understand if the company is running its
business efficiently
1. Inventory turnover
2. Average collection period
25. Inventory Turnover
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How fast are company’s goods selling?
Inventory Turnover = Cost of Goods Sold /
Average Inventory
Fast inventory turnover implies the company is able to
sell off its inventory quickly
26. Average Collection
Period
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Is the company able to collect payment from its
buyers quickly?
Average Collection Period = (Days x Average
AR/Net Credit Sales)
Quicker collection means cash comes in faster and
can be reinvested in the business faster. This has
major impact on growth rates.
28. Is Debt
Supporting or
Hindering the
operations?
These 2 key leverage metrics help you
understand if the company prudently
using debt to fund its business
1. Debt ratio
2. Debt to Equity ratio
29. Debt Ratio
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How leveraged is the company?
Debt Ratio = Total Debt / Total Assets
There is a optimal amount of debt for every company.
Debt is important as debt is a cheaper way to fund the
business than equity. However, too much debt can
compromise the financial flexibility of the company.
Think of Debt Ratio as a measure of whether the
company is using adequate amounts of debt
30. Debt to Equity Ratio
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Similar to the Debt Ratio and used for similar reasons
Debt to Equity Ratio = Total Liability /
Shareholder’s Equity
Debt to Equity ratio can stand as a proxy for risk in the
business. A high Debt to Equity ratio means the
business is highly levered and therefore inherently
risky