Key financial metrics can be helpful while finding long term investing opportunities in the stock market.
One of the main objectives of a value investor is to pick a stock that they believe is undervalued. They use different financial metrics to analyse a company’s fundamentals and valuation.
One of the most well-known value investors Mr Warren Buffett uses fundamental analysis to pick stocks.
In this article we have listed 10 key financial metrics that are used by financial analysts and value investors as a part of fundamental analysis while making investment decisions in the stock market.
Here is the list of 10 Key financial metrics we will be discussing in this article;
- Earnings per Share (EPS)
- Price to earnings ratio (P/E)
- Price to book value ratio (P/B)
- Profit margin
- Dividend payout ratio and Dividend yield
- Price to free cash flow ratio
- Debt to equity ratio (DE)
- Return on assets (ROA)
- Return on equity (ROE)
- Quick and current ratios
Earnings per Share (EPS)
A popular means of measuring a company’s performance is earnings per share (EPS). You will find this financial metric almost in every financial website and annual report.
Both basic and diluted earnings per share (EPS) can be found at the bottom of the company’s income statement. EPS shows per share rights of the shareholder on the company’s earnings.
You can calculate EPS by dividing the company’s net earnings by the total number of shares outstanding. If the EPS of a company is 10 and market price is Rs 100, this means you are paying Rs 100 per share to get rights of Rs 10 on the company’s earnings.
Sometimes the earnings per share figure is referred to as being diluted.
This arises where a company has issued securities which have the right to convert into equity shares at some future date. The diluted earnings per share is calculated assuming that this conversion has taken place, showing the position if all the possible options were taken up and shares were issued. Often a significant factor in arriving at the fully diluted earnings per share will be the share options of directors and other employees.
Earnings per share will show your rights on the company’s earnings. If EPS is 10, it means per share earnings right is Rs 10.
Price to earnings ratio (P/E)
A discussion of important stock market financial metrics would be incomplete without mentioning the price to earnings ratio.
Price to earnings ratio or PE multiple is calculated by dividing a company’s share price by its annual earnings per share.
P/E ratio shows how much investors are paying for one rupee of a company’s earnings.
A high PE multiple indicates that the market is expecting the company’s future earnings to grow at a higher rate. To some investors, a higher P/E ratio compared to industry average and other competitor’s PE multiples appear overvalued.
In reality, a high or low PE multiple does not make any sense if you don’t analyse a company’s fundamentals. We have companies which are continuously trading for years at a higher PE ratio.
However, it tells you the present valuation of a company. If other fundamental factors indicate that the company will keep growing at a higher rate of earnings, then many growth investors prefer to buy at the current PE. The only way of deciding whether a company has a high or a low P/E ratio is to compare it with other companies in the same industry.
The modified version of the P/E ratio that also takes earnings growth into account is known as PEG ratio.
The PEG ratio measures the relationship between the P/E ratio and earnings growth. A stock with a PEG of less than 1 is considered undervalued and a PEG greater than 1 considered overvalued.
Price to book ratio (P/B)
Price to book ratio is another financial metric used to know whether the stock is undervalued or overvalued. You can do it by comparing the company’s net asset with the price of the all outstanding shares.
Price of the all outstanding shares is known as market capitalization.
In other words, Price to book ratio is calculated by dividing stock’s market price by its book value per share.
Price to book ratio shows that investors are willing to pay for each rupee of a company’s net asset or book value. It shows the difference between actual book value of the company and its market price.
A price to book ratio of 1 means the underlying stock is trading at a price which is the same as its book value per share. A company with good fundamentals at a less than or trading at nearly book value is considered as a good investment opportunity for value investors.
In a rising market, it’s very difficult to get fundamentally good stocks trading at or near its book value.
Net asset is calculated by taking out liabilities from the company’s assets.
In most of the financial websites you will find it showing as “P/B”.
P/B means price to books ratio of the company.
Typically, profit margin means the net profit margin of a company. It’s calculated by dividing a company’s net profit over total revenue.
Net profit margin indicates the amount of profit a company makes for every unit of sales.
While comparing net profit margin, you should consider companies within the same industry. Industry wise profit margin might change.
Higher net profit margin indicates that the management is very efficient in pricing the product higher than its costs to make higher profit.
In contrast, low profit margin indicates inefficient pricing strategy due to which the company is not able to make enough profit to cover its expenses.
Long term investors always look for stock which offers growth in revenue and profit margin.
EBITDA to sales ratio is another profit margin ratio which can help you to analyse the profitability of the business better.
EBITDA stands for “earnings before interest, taxes, depreciation and amortisation”.
If you divide EBITDA by its net sales, then you get an EBITDA-to-sales ratio. This financial metric shows the company’s appetite for the amount of debt it believes the business should have.
Dividend payout ratio
The dividend payout ratio is the percentage of a company’s net earnings that they paid to shareholders in the form of dividends.
Dividend payout ratio can easily tell you how much percentage of the total earnings the company has kept for reinvesting and how much they have distributed among existing shareholders.
A higher percentage indicates that the company has reinvested less money back into the company.
Dividend yield is a financial metric which can help you to find out the return the company has paid in the past on its share prices every year. Based on its past record, you can expect the company to maintain similar returns in future based on its fundamentals and earnings growth.
Price to free cash flow ratio
Price free cash flow ratio is calculated by dividing the company’s share price by the operating free cash flow per share.
Value investors look for stocks with growing free cash flow that are selling at a bargain. These types of investors believe that free cash flow is harder to manipulate than earnings.
A lower ratio indicates a company may be undervalued, while a higher ratio may signal overvaluation.
Debt to equity ratio
To get the debt to equity ratio of a company, you need to divide the company’s total liabilities by its shareholder equity.
Debt to equity ratio compares a company’s borrowed fund with equity capital to explain financial leverage.
You have to compare debt to equity ratio with other companies from the same industry. Utility and infra sectors require higher debt due to the nature of business. Therefore you can not compare the debt to equity ratio of a company from the power sector with another company from the IT sector.
Return on assets (ROA)
Return on assets is a financial ratio that indicates the efficiency of the management in terms of profitability of a company in relation to its assets for a period.
High return on assets means the management is very efficient and productive while using assets of the company to generate profits.
In contrast, a lower return on assets indicates inefficiency of the management.
Return on assets investment ratio should always be used as a comparative measure. This means it’s better to compare a company’s present return on assets with the previous return on assets numbers and with other similar types of company’s return on assets.
Return on equity (ROE)
Return on equity is another investment ratio which compares the equity capital with the company’s return.
Return on equity, popularly referred to as ROE, measures how successful a company is by using shareholders capital to produce profit. In simpler terms, return on equity is known as net profit earned by the company on its equity share capital.
Return on equity is the most commonly used financial metric by value investors to measure the return on the owner’s investment in relation to net earnings.
Here is the basic formula to calculate Return on equity:
ROE = Net profit available for common stockholders / Shareholders equity
The main difference between return on assets and return on equity is that the ROA takes companies debt into account while ROE does not.
Quick and current ratios
Current ratio is calculated by dividing current assets by current liabilities.
Instead of taking current assets in numerator, you take only highly liquid current assets such as cash, marketable securities and accounts receivables, which can easily be converted to cash and divides this sum by current liabilities to get a quick ratio.
Quick and current ratio measures the company’s liquidity position, which means they will tell you how efficient the company is when it comes to payment of short term liabilities.
In other words, these quick and current ratios of a company tells you whether the company has enough working capital to handle economic downturns or financial setbacks,
High quick and current ratio indicates higher liquidity. In contrast, low quick and current ratio indicates that the company cannot meet short term obligations.
Remember, no single financial metric can determine which stock to buy or sell with 100% certainty.
There is no right or wrong way to analyse a stock.
Value investors always try to purchase quality companies at a good price and hold on to those stocks for the long-term.
As a value investor, you should combine several key financial metrics to analyse the company to form a more comprehensive view of a company’s financials, its earnings, and valuation.