In addition to the Earnings per Share (EPS), Price/Equity (P/E) and Price/Book (P/B) ratios discussed in our previous segment (Fundamental Analysis – How to Value a Company), here are four major ratios that are used to value a stock when applying the fundamental analysis approach:
- Efficiency Ratios
- Liquidity Ratios
- Leverage Ratios
- Profitability Ratios
Efficiency Ratios: These ratios measure how efficiently a company uses its assets to generate profits
- Inventory Turnover = Cost of Sales/ Average Inventory: Indicates how well a company is managing its inventory. A higher turnover ratio is a good thing
- Accounts Receivable Turnover = Revenue / Average Accounts Receivable: Indicates whether the company is following an effective credit policy. Low values might indicate that the company is overextending credit to its customers. A higher turnover ratio is a good thing
Liquidity Ratios: These ratios measure the financial health of a company and its ability to meet its near-term debts
- Current Ratio = Current Assets / Current Liabilities: Tells you if the company can meet short term liabilities using short term assets. A ratio of 1 or greater is good. A value of less than 1 may mean the company has liquidity challenges
- Cash Ratio = (Cash + Short-Term Investments) / Current Liabilities: Tells how well a company is covered by the most liquid of assets (Cash and other easily convertible investments) to meet its short-term liabilities. A higher ratio is preferred
Leverage Ratios: These ratios also measure the financial health of a company, but take a look at the company's debt levels to do so
- Debt/Equity Ratio = (Short Term Debt + Long Term Debt) / Total Equity: Provides a measure of how much a company is funded through debt as opposed to equity invested by shareholders. Generally, companies with low D/E ratios pose a lower risk than those with higher ratios
Profitability Ratios: These ratios focus on addressing questions like 'How profitable is the business?' and 'Is the company's profitability better or worse than its competition?'
- Gross Margin (%) = Gross Profit / Sales: Indicates how much of each dollar of Sales the company retains in the form of Gross Profit. A higher value is preferred
- Operating Margin (%) = Operating Income or Loss / Sales: Tells you how much a company earns or loses for every dollar of sales. A higher value is preferred
- Net Margin (%) = Net Income or Loss / Sales: Indicates what percent of its revenue a company retains once all expenses are deducted from all its revenue. A higher value is preferred
- Return On Assets (%) = Net Income + After tax Interest Expense / Average Total Assets: Gives shareholders a sense of the company's ability to use its assets profitably. A higher value is preferred
- Return On Equity (%) = Net Income / Average Shareholders' Equity: Measures the return that the company has able to deliver on shareholders' investments. A higher value is preferred
The discussion in this article and the overall “How to Value a Stock” series provides you with a "general and high level understanding" on how to use Fundamental Analysis and interpret the derived results.
Note, however, that these high-level guidelines might not always hold true. For instance, a low Price/Sales ratio for a company that consistently reports losses is of no benefit to an investor. Similarly, a high Price/Earnings ratio (say of 60) does not mean a stock is expensive, especially if the Industry P/E is hovering around 150, or the P/E of its key competitors is above 60.
It is therefore recommended that investors use the Fundamental Analysis approach in conjunction with the Technical Valuation Analysis approach, and not in isolation, when making investment decisions.
(By: Monty R. – MarketConsensus News Contributor)
Stock Valuation Series