Important financial ratios you need to pick stocks
Bow Tie Nation! What’s going on, your Bow Tie warrior here Joseph Hogue with the Let’s Talk Money channel, lovin’ this series of investing videos and today we’re bringing it all together with the 10 financial ratios every investor MUST know.
Nation over the last two videos, we’ve talked about how to read a stock and last video I went step-by-step through the stock analysis process I used as an investment analyst. But these ratios are so important because not only are they going to help you understand if a company is heading in the right direction, these 10 financial measures are going to help you avoid those worst stocks that lose your money and pick the best investments in the market.
I’ll show you each of these investing terms, what it means and how to use it in your analysis. I’ll reveal which are the most important and my two favorite, the two financial ratios that every analyst goes to immediately when they’re looking at a new stock.
We're building a huge community on YouTube to beat your debt, make more money and start making money work for you. Click over to join us on the channel and start creating the financial future you deserve!
Join the Let's Talk Money community on YouTube!
Make sure you stick around for that last one because, while it is a little more technical, this is the bread-and-butter for Wall Street analysts. Most investors don’t know about it and it WILL give you an edge in picking stocks.
How to Use Financial Ratios
Now as we’re working through these financial ratios, remember there are two ways to use these. First is comparing it with the company’s own historical trend.
So if we’re talking about a company’s return on equity, how well it produces shareholder value, and we get something like a 15% ROE, how is that compared to what the company did last year or over the last ten years? If that return on equity has been trending down for a couple of years, say from 20% three years ago, you better believe I’m looking for a reason and a plan by management to boost it again.
The second way to use these ratios is comparing them against competitors in the same industry. For example, IBM books a 49% return on equity versus just 30% at Cisco and 44% at Microsoft. How is management at IBM able to get that return, can they keep it up and does it tell us the company has a competitive advantage over these peers?
That last part about comparing a company against others in its own industry is important. Comparing some of these ratios for a stock like Microsoft against numbers you see in something like Proctor & Gamble isn’t going to tell you anything. The business models and the environment in which these two companies compete are just too different. Just because management at Proctor & Gamble is only able to eke out a 10% return on equity doesn’t mean you should avoid it and jump into the three tech names. It might be that, compared to its peers in the consumer staples sector, Proctor & Gamble has an amazing ROE and is using that to really reward investors.
It’s why one of my favorite tabs in our Portfolio Spreadsheet I developed is this comparison tool. With the spreadsheet, you can put in two stock symbols here so we’ll do Nike and Coca Cola, click compare and the spreadsheet is going to pull all this financial information from the internet. You can compare the price-to-earnings ratio of a company against the average for the sector as well as against another stock. We’ve also got the price-to-sales ratio, some of these profitability measures like the operating margin and profit margin and other comparisons for debt-to-equity and dividend yields.
Now let’s get into those 10 financial ratios but I also want to hear what you do to analyze stock picks. What are the financial measures and analysis you use when looking for those best stocks to buy. So scroll down and let us know in the comments, which ratios do you use?
Price Ratios for Comparing Stocks
Our first four ratios are everyone’s favorites, the price multiples with price- to earnings, sales, book value and my favorite Enterprise Value-to-Sales.
Price multiples give you an idea of value in a stock, what price are investors willing to pay for the company’s earnings or sales and is that too high, low or just right?
It’s easy to see why investors love these so much because they tell you if you’re getting a good deal!
Finding any of these is really easy and we’ll cover the first three together then enterprise value next. These are always on a per share basis, so the price of each share divided by the earnings per share or the sales per share.
Earnings are usually given on a per-share basis but to find the other two, you’ll probably have to divide them by the number of shares outstanding. Finding this is easy enough. You can either look for the number of shares on something like the Statistics tab for a company on Yahoo Finance, or just take the market value of the company divided by the price per share and that will give you shares outstanding.
So you’ve got this price-to-earnings or the PE ratio, but what does it mean? We can see that shares of Apple trade for 25-times its earnings. Apple made $12.75 in net income per share last year and investors are paying 25-times that, or around $318 for each share of stock.
Again though, you can compare this with the history of the stock. If we look back, we can see that shares of Apple traded for 15-times earnings less than a year ago and have traded for as low as 10-times earnings over the last decade. Just going on that tells us that shares of Apple are pretty expensive right now unless you think earnings are going to grow very quickly over the next year or two.
You can also compare that PE ratio against peers like Samsung or Sony, are shares of Apple expensive or cheap compared to these competitors.
And while everyone loves to use that PE ratio, I like these others a little better. If you remember from that second video when we looked at the income statement, the numbers on this statement are very easy to fudge. Management can give more credit to customers so it increases sales, it can defer paying some expenses or convert some into long-term investments so they don’t count against profits this quarter, like what AOL did with those annoying CDs in the 90s. All these shenanigans can be played to make earnings or net income look higher than it actually is and higher earnings mean a lower price-to-earnings ratio and a stock that looks like a great deal.
Instead, I’ll use the PE ratio but I also use the price-to-sales ratio as a double-check. For financial companies like banks and insurance, the price-to-book ratio is a great measure because their assets and liabilities are usually pretty close to market value. With most other companies, you don’t get that and the book value isn’t as close to actual market value.
This enterprise value-to-sales is a little different but the preferred ratio by a lot of analysts, especially venture capital and M&A analysts. While these other value ratios only account for the market price of the stock, so that stock price over sales, the enterprise value is more like the company’s total value.
Here’s what you do to find the enterprise value. Take the market cap of a stock, remember from our first video on how to read a stock, that’s the total value of all shares of the stock in the market. Then you go to either the balance sheet which shows you everything the company owns and owes, and look for two things; the cash and marketable securities, that’s how much liquid cash the company has in the bank, and the company’s long-term debt.
Now here’s where it gets fun, OK fun for us investing nerds! Think of the enterprise value as what a takeover buyer, one of those corporate raiders of the 80s, would have to pay for the company. It’s the market value of the shares, minus the cash the company has in the bank because someone could buy the company and have all that cash as an immediate discount. So you take the cash available off that market cap but you add the amount of debt because taking on this company means a buyer would also now be responsible for the debt.
So again, market cap minus cash and plus long-term debt – it’s a much better estimate of the company’s value than just taking the stock price. And you can take this number divided by sales, an enterprise-to-sales ratio, for a great look at valuation.
I know, it’s a little more complicated than just looking at the stock price versus earnings or sales but this enterprise value-to-sales ratio is so much better, especially for companies that owe billions in debt. All that debt, that financial risk, doesn’t show up in the stock price so there’s no way to measure it in a simple PE ratio.
Financial Ratios for Comparing Management
Our next ratio is a great one for measuring management’s ability to get you the best return for your money, the return-on-equity or ROE.
Return on equity is super simple to calculate, you just take the company’s net income, that’s found on the income statement. Take that and divide by shareholders’ equity which is one of the last lines on the balance sheet.
So if we look at these two pieces, ROE shows you how much money, that net income, management is able to produce each year on the equity ownership in the company. It’s how much the shareholders’, that’s you, get as an earnings return on your money.
Now I have a love-hate relationship with the ROE. On one hand, there are so few good management return measures so you really do need it in your toolbox. It’s very easy to calculate and most investing sites do the calculation for you, for example here on Yahoo Finance on the Statistics page.
But as we talked about earlier, that net income is a terrible number. There is so much shenanigans by the time you get to that bottom-line number; from deferring expenses to booking questionable sales, use of taxes to skew the numbers, you just can’t trust net income…so any ratio that uses it, like the return-on-equity, is going to be of questionable use as well.
That said, I would still put this one in my toolbox for analysis. With all the other ratios, if you still can’t decide between one stock or the next, the ROE can be a tie-breaker ratio.
The Best Financial Ratio You NEED to Use
Next I’ve got to apologize to everyone here in the Nation because you’re going to have to hear me talk about the operating margin again.
My Bow Tie warriors, you know the operating margin is my favorite financial ratio. The Operating margin is the percentage of sales left over after paying operating costs to run the company. It’s a pure measure of how efficiently management turns those sales into profits because it only includes those operating costs, not the effect of taxes or financial leverage which appear further down on the income statement.
So the operating margin is the operating income, that’s usually about halfway down on the income statement, divided by the sales or total revenue reported at the top of the page.
That percentage profitability can tell you a lot about a company. How well does management turn those sales into profits, again versus its own historic trend and against competitors. A company that can get more profit out of its sales is going to take more market share, grow faster and ultimately just be a better return for investors.
Financial Ratios for Dividend Investors
Our next ratio is a big one for dividend investors, the payout ratio.
The payout ratio is how much of a company’s earnings it has to pay out to cover the dividend. Not only will it show you if a company’s dividend is in danger of being cut, it gives you an idea of how fast the company can grow and even if it might increase the dividend.
So if we take the dividend amount, not the dividend yield, but the actual dollar amount of the dividend paid over four quarters, then you divide that by the net income per share or earnings per share of the company. That’s going to give you a percentage, say 0.25 or 25% and means the company uses 25% of its earnings to pay that dividend.
Now there are a few ways to use this information in your analysis. One, is the company paying out more or less of its earnings for the dividend compared to peers? A company paying out almost all its earnings isn’t saving much back for growth, so it that high payout ratio going to mean the company can’t compete against competitors and maybe falls behind in growth? Also, if the payout ratio is trending higher over the last few years, will that mean dividend increases are reduced or maybe even cut? Cutting the dividend is a last resort for mot companies but it does happen when earnings fall. You can’t pay out 100% of earnings as dividends for long.
A warning here though. You cannot use the payout ratio for companies with a high amount of depreciation. This is going to include real estate stocks, so REITs, or energy master limited partnerships, MLPs. The problem here is that these companies report so much depreciation on the income statement, so that tax write-off from owning property or capital assets, that it totally skews net income lower. The payout ratio for REITs and MLPs will tell you nothing because the net income even a worse measure here than it is for other stocks.
Financial Ratios for Stock Risk
Just one more ratio before we get to those two that every investor should be using, and this one is the debt-to-equity ratio.
Debt-to-equity is another easy one and is helpful in seeing the amount of financial risk in a company. It’s going to show you how much debt the company owes compared to how much shareholders actually own.
This is just the total liabilities of a company, that’s going to be almost to the bottom of the balance sheet, divided by total shareholders’ equity which is a little further down.
So how much debt does the company owe, how much of that financial leverage is it using, compared to the total shareholder value in the company. Understand that debt isn’t necessarily a bad thing for companies. It helps them get cheap financing and not dilute stockholders. If a company used no debt to pay for projects, then it would need to sell more stock which would mean you’d have to share those earnings with more investors.
Just like all these other ratios, compare the debt-to-equity ratio of a company only with others in its industry or sector. Comparing the debt-to-equity of a utility company which can easily be in the high sixty- or seventy-percent range with a tech company and a ratio of maybe 25% debt to equity doesn’t tell you anything. Utility companies have very stable cash flows which means they can use lots of cheap debt for funding. Tech companies though are paying much higher interest rates so they tend to use less debt in the capital structure.
The debt-to-equity is another one I made sure to include in our stock comparison spreadsheet so you can easily compare it against other companies or the sector itself.
My Favorite Financial Ratio
Now I saved this last ratio for the end because it’s harder to calculate, definitely more technical, but for anyone with the dedication to stick around to this point, this is one of the best ratios to analyze a stock.
I’m talking about the growth in Cash Flow from Operations compared to earnings growth.
Remember from our video on the financial statements, the Statement of Cash Flows is a real picture of cash in and out of the company. There are still ways management can fudge these numbers but it is so much harder to manipulate this statement compared to when you’re looking at the income statement.
So this is a much purer picture on the strength of a company, that Statement of Cash Flows.
And that first section in the statement, the Cash Flows from Operations, that’s showing you the actual cash-generating power of this business. If we look at the line, cash flow from operations, it’s showing us how much cash the company is bringing in from the core business and you can take that divided by previous years to get a growth rate in this cash flow.
What you can do is find the growth rate of those operational cash flows, and we’ll look at an example next, and then you compare the growth in cash flow to the growth rate of earnings on the income statement.
What this is going to show you is quality of earnings. If the net income or earnings reported are high quality, the growth in this number should be pretty close to that growth rate in actual cash collected.
Let’s look at an example and I think it will make more sense. Here we have the Statement of Cash Flows for Apple, and I’ve only taken the top section for cash flow from operations. The company booked $69.39 billion in 2019 cash flow and $65.82 billion in 2016 cash flow.
I like to use a longer-term measure of this growth rather than just one year to the next. Over any give year, any of these numbers can jump around a lot but if you look at a longer-term trend like three- or even five-years, you see a clearer picture.
So I’ll take that $69.39 billion in 2019 operational cash flow and divide it by $65.82 billion for 2016 which gives me 1.054 and if we get a three year annualized it comes out to growth in cash flows of 1.74% a year.
Now Apple’s cash flow has jumped around a lot over the last few years so I’d want to look into that anyway. Why did cash flow fall in 2017 and again in 2019?
But if we go to the income statement, and look for this Net Income Available to Shareholders, we see Apple reported $55.26 billion last year and $45.69 billion in 2016. Again, we divide the 2019 number by the one reported in 2016 and get the annualized for a 6.5% yearly growth in net income.
That’s a pretty big difference so I’d want to look at little further out, maybe the last five or ten years. But the fact that a company reports faster growth in net income than actual cash flow doesn’t automatically mean it’s the next Enron. There are a lot of reasons why these can be legitimately off. For example, companies that make sales on credit, giving buyers time to pay, might book sales in one period but not actually get the cash until another.
So there is almost always going to be a difference in these numbers, but it becomes a problem when the difference gets progressively wider and goes on for years.
Invoiced customers have to eventually pay and you expect a lot of these differences between cash and income statement to balance out over years. When that doesn’t happen, it can be a warning of two possible culprits.
First, if management is playing shenanigans with the income statement. Using legal and not-so-legal accounting tricks to make earnings look better than they actually are…that’s going to show through in net income growth that’s faster than cash flow.
It can also be a sign of bad investment decisions on the part of management. If the company is investing in a lot of equipment and other assets that are getting depreciated on the income statement but never result in much cash flow…then it might not necessarily mean management is doing anything illegal but they definitely aren’t helping investors any.
I know this is a lot of accounting to throw at you but this is one of the best ways to compare companies and find those quality earnings that grow a stock. A company’s management can fudge its income for only so long. Eventually, the company’s with that best quality income, the ones where actual cash flow matches up with net income growth, those are going to be the ones that reward shareholders with higher returns.
Track your entire portfolio, see the gaps in your investments and compare two stocks instantly with my Portfolio Tracker spreadsheet.
Don't over-complicate investing. There are thousands of investing terms and ways to analyze a stock but you really only need a handful of the most important financial ratios to do 90% of the research. Stick with a basic list of stock ratios and make investing easy!