Fundamental Analysis and Ratios
Fundamental analysis is evaluating company’s stock to find intrinsic value and analyze factors that may affect the price in the future. Examples- Financial statements, industry trends, competitors performance, economic outlook.
Financial ratios become a powerful tool to evaluate how attractive a potential investment might be when compared to other companies in the same economic sector, to the broader market, or changes over time. Financial ratios are usually used to analyze liquidity, profitability, and some use of debt.
There are lots of ratios that investors and traders use but below is the list of the most relevant and important.
Profitability Indicator Ratios
- Earnings per Share
- Effective Tax Rate
- Return On Assets
- Return On Capital Employed
- Return On Equity
- Overview Of Debt
- Debt-Equity Ratio
- Debt Ratio
- Capitalization Ratio
- Interest Coverage Ratio
- Cash Flow To Debt Ratio
Cash Flow Indicator Ratios
- Operating Cash Flow/Sales Ratio
- Free Cash Flow/Operating Cash Ratio
- Cash Flow Coverage Ratio
- Dividend Payout Ratio
Liquidity Measurement Ratios
- Working Capital Ratio
- Quick Ratio
- Cash Ratio
- Cash Conversion Cycle
Operating Performance Ratios
- Fixed-Asset Turnover
- Sales/Revenue Per Employee
- Operating Cycle
In our opinion you don’t have to use all of this financial ratios, the most important ratios for me that could help you pick the best stocks for your portfolio are :
- Earnings per Share – Earnings per share (EPS) measures net income earned on each share of a company’s common stock. The company’s analysts divide its net income by the weighted average number of common shares outstanding during the year.
- Price/Book ratio – The price-to-book ratio (P/B Ratio) is a ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry
- Debt-Equity Ratio – This ratio is very important for me and I always take a look at this ratio on the balance sheet of each company. I always check this numbers in latest quarterly and annual report. The debt-to-equity is calculated by adding outstanding long and short-term debt, and dividing it by the book value of shareholders’ equity. This ratio has to be analyzed in terms of industry norms and company specific requirements. For example, some company has $1 million short-term debt and $4 million long-term debt, shareholders’ equity is $20 million. In this case, debt-equity ratio is 0.25, which is acceptable under most circumstances.
- Return on Equity – All investors want to know how profitable their capital is in the stocks they invest it in. Return on equity is calculated by taking the firm’s net earnings (after taxes), subtracting preferred dividends, and dividing the result by common equity dollars in the company. For example, net earnings of some company are $2.6 million, preferred dividends are $600,000 and the common equity is $16 million. In this case ROE is 12.5%, the higher the ROE, the better the company is at generating profits.
- Price-Earnings Ratio – This is also one of my favorites ratios because this ratio tells how much some stock is undervalued or overvalued. Called P/E for short, is calculated by dividing the share price of the company’s stock by EPS. This ratio also reflects future earnings and my opinion if P/E is under 15 that stock could be a good opportunity for the investors. For example, some company has EPS for the past 12 months averaged $6, the price of the stock is $55, then the P/E ratio would be $55/$6 = 9.16. If P/E is above 50 or negative we would not consider investing in that stock.
- Working Capital Ratio – The working capital ratio is calculated by dividing current assets by current liabilities and this ratio shows the health of a company. Investors will know how easily some company can turn assets into cash to pay short-term obligations by checking this ratio. For example, some company has current liabilities of $5 million and current assets of $10 million. In this case working capital ratio is 2:1. But if two similar companies each had 2:1 ratios, but one had more cash among its current assets, that firm would be better able to pay off its debts quicker than the other.
$AAPLs financial Ratios(from Finviz).
Other important things that all investors should check beside this ratios are revenues of companies that they want to invest in. The good company will have a rise in revenues year after year and I always check revenues in several last years and quarters. This is very important because if some company has significant fall in revenues that could be the beginning of problems (significant fall in revenues is above 6% annually). In my opinion, every trader or investor who wants to become profitable should use a combination of technical and fundamental analysis to make decisions. Fundamental analysis helps you to figure out the real market value while technical analysis helps you to find a better entry or exit position by predicting price movement. Investors and the long-term traders are generally more focused on the fundamental analysis while short-term traders usually trade according to technical analysis in order to profit from short-term price moves instead of waiting to profit from long-term price movements. Financial ratios usually look at data over multiple quarters or years and the analysts that look at this ratios are trying to determine a real market value of some stock. The trader or investor who makes money on a consistent basis generally follow a written trading plan. Every trading plan uses personal trading styles and goals like specifications for trade entries and exits, trade filters and triggers, money management, risk level, time frames, order types, and other important information. Some analysts believe that US stock market is bit overvalued although you can still find good and undervalued stocks.