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The initial question that comes to every beginner’s mind when picking their first stock to invest in would be: “How does one value a stock or compare the company’s financial position to that of its competitor?”
The simplest yet most efficient method would be to focus on three financial statements namely, Income statement, Balance Sheet and Statement Of Cash Flows.
Here, we aim to point out the merits in each of the seven financial metrics and explain the importance of these figures obtained through the financial statements provided by the company. At the end of the article, we have also included a valuation BONUS ratio that has been widely popularised by Benjamin Graham (one of Warren Buffett’s mentors).
Income Statement
Income statement reflects all revenue gained or expenses incurred with regards to production of the revenue for a given period such as quarterly, semi-annually or annually (for e.g. Twelve Month Period Ending December 31, 2017). This would result in a net profit or loss when total revenue exceeds the expenses produced for a given period or vice versa.
1.Gross Profit Margin (GPM) tells us the percentage of gross profit that is generated for every single dollar of revenue. Given a higher GPM compared to its competitor, the company is better in generating profits which exhibits better efficiency, making it an attractive investment choice since they are able to sell similar inventories with significant profits when compared to its competitor.
Warren Buffett’s General Rule: GPMs greater than 40% usually have some form of competitive advantage. GPMs with lower than 40% but greater than 20% are usually businesses in a highly competitive industry. GPMs lower than 20% are in a fierce competition. Quoted from “Warren Buffett and the Interpretation of Financial Statements”
Gross Profit Margin (%) = [Gross Profit / Revenue] x 100
2.Net Income Growth Rate tells us the percentage gain (or loss) in net income over a given period. Mostly stocks with higher net income growth rates are preferred over than the lesser ones since it illustrate the rate at which companies increase their profits over the period.
The growth rate builds up for an in-depth analysis as comparison made between companies have to be in the same business life cycle, instead of solely based in the same industry. This figure also indicates stability in financial profitability throughout the past periods for the company.
Net Income Growth Rate (%) = [{Net Income (current period) / Net Income (previous period)}-1] x 100
Balance Sheet
Balance sheet is a financial statement that summarises all of the firm’s assets, liabilities and shareholder’s equity as of the end of the reporting period. The assets in the balance sheet is derived from the two ways of financing for a company which are debt and equity financing, implying that assets should equate to liabilities plus shareholder’s equity.
3.Return on Equity (ROE) bearing some resemblance to financial measure, Earnings Per Share (EPS). This figure measures the firm’s efficiency in generating profits through the amount of money shareholders have invested.
ROE is mostly considered a better measurement than EPS as it displays how a firm is utilising its equity to build a profitable business. Higher ROE would mean that more profits are generated by the company using the shareholder’s equity leading to higher returns. While ROE may serve as a better comparison for profitability among companies in the same industry, EPS on the other hand, would make a better comparison whether the stock is overvalued or undervalued.
Return On Equity (%) = [Net Income / Shareholder’s Equity] x 100
4.Debt-to-Equity ratio (D/E) shows the relative amount of company’s assets that are funded through debt financing. Generally, it is used to evaluate the financial soundness of the company since the ratio indicates the extent to which shareholder’s equity can meet its obligations towards creditors in case of liquidation.
Low D/E ratio is often preferred because investor’s interest is protected in case of a downturn since they are able to get back a portion of their initial investment. However, very low D/E ratio may not be appealing as the firm might not be capitalising on the amount of increased profits that financial leverage may bring. Ultimately, analysing between companies in the same industry with similar D/E ratio while distinct differences in earnings, helps to determine which company is more efficient in employing financial leverage.
Debt-to-Equity Ratio (D/E) = [Total Liabilities / Total Equity]
Statement Of Cash Flows
The cash flow statement records cash flows activities determined by three components, Operations, Investing and Financing that are entering and exiting the firm for a given period. From this financial statement, investors can dive deeper into cash inflows and outflows by the different components, to be informed of certain undesirable cash flow figures that may threaten the business.
5.Earnings Per Share (EPS) is one of the most commonly used financial measure to determine a company’s profitability. The figure is the amount of company’s profit gained minus preferred dividends and then divided by every outstanding share of the stock.
Companies that possess high EPS would be attractive in an investor’s eye since it’s an indication of more retained earnings for growth rate, if not larger dividends would be paid out to shareholders, a win-win scenario for any investor. One still has to be wary as companies can buy back their share without increasing their net income to increase its EPS.
Earnings Per Share (EPS) = [Net Income – Preferred Dividends] / [Weighted Average Outstanding Shares]
6.Operating Cash Flow Ratio (OCF) can gauge the company’s liquidity in short-term by determining its capability to pay off its current liabilities through cash flow generated by the company’s operations.
Given that OCF ratio is less than 1, it’s an indication that the company is unable to generate enough cash to pay off its current liabilities which normally signals to investor that the company is in a risky financial position. Without any actions taken immediately or in the next period, the company is most likely unable to continue its function.
Operation Cash Flow Ratio (OCF) = [Cash Flow From Operations / Current Liabilities]
Valuation Bonus Ratio
7.Price-to-Earnings Ratio (P/E) is a valuation measurement that requires the calculation of EPS and current share price. From the ratio, it tells us how much investors have to pay for every single dollar of current earnings.
The P/E ratio provides a benchmark to compare valuations across the industry. When faced with two similar companies in the same industry, the one with a lower P/E ratio would definitely be more enticing since it costs less per share for same level of financial performance. Companies with high P/E ratio may be deemed as overvalued and investors can make a comparison to the industry average to further justify the company’s value.
Guest Blog- sharesinv.com
