Stock Investing Ratios

Now that you have learned about financial statements ( the language of business), let's learn the basic language of invesing.

Stock investing ratios are a common tool investors use to relate a company's stock price with an element of the underlying company's performance. But before we calcualte any ratios, you must leaarn some essential definitions.

Earnings per share is a company's net income (typically over the trailing 12 months) divided by the number of outstanding shares. EPS comes in two different varieties: basic and diluted. Basic EPS include only the outstanding shares of a company's stock, while diluted EPS represents all of the potential stock that could be outstanding with current stock options grants and the like. Diluted EPS is the more conservative number. Although EPS can give you a quick idea of a company's profitability , it should not be used in isolation without also looking at cash flow and other performance metrics.

Market Capitalization is essentially the market value of a company. It is calculated by multiplying a company's outstanding shares by the current share price. For example, if there are 10 million outstanding shares of XYZ Company, and each share sells for $25, then that company has a market capitalization of $25 million. Market capitalizaion not only gives you an idea of the size of the company, it also can be used when calcualting the basic valuation ratio.

Just as there are three types of profits-gross, operating, and net- there are also three types of profit margins that can be calculated to offer insight into a company's profitability. Margins are usually stated in percentages.

Gross Margin= Gross Profits / Revenues

Operating Margin= Operating Profits / Revenues

Net Margins= Net Profits / Revenues

Price to Earnings and Related Ratios

One of the most popular valuation measures is the price to earnings ratio or P/E. The P/E is the price of a stock divided by its EPS from the trailing four quarters. For example, a stock tradig at $20 a share with earnings of $1 per share during the past 12 months has a P/E of 20. The P/E ratio gives a rought idea of what investors are paying for a stock relative to its underlying earnings. It is a quick way to gauge how cheap or expensive a stock may be. Generally, the higher the P/E ratio the more investors are willing to pay for dollar's worth of earnings. Higher P/E stocks tend to have a higher growth rate or the expectation of a profit turnaround. Lower P/E stocks have a lower growth rate and lessor future prospects.

The P/E can also be useful to compare to competitors to see how they stack up. You can also compare a company's P/E with the S&P 500 or some other benchmark index to see how richly a stock is valued relative to the broader market.

One variant of the P/E is earnings yield, or EPS divided by the stock price. Earnings yield is the inverse of P/E, so a high earnings yield indicates an inexpesive stock, while a low earnings yield indicates a more expensive stock. It can alos be useful to compare earnings yield to a 10 year of 30 year bond yield to get an idea of how expensive a stock is.

Another variant is the PEG ratio. A high P/E generally means the market expects the company to grow its profits rapidly in the future, so a much greater percentage of the potential earnings are in the future. This means that its market value is relatively large in relation to its present-day earnings. The PEG can help determine if stock's P/E has gotten to high in these cases by giving you an idea of how much investors are paying for this company's growth. A stock's PEG ratio is a forward P/E divided its expected earnings growth over the next five years as predicted a consensus of Wall Street estimates. For example, if a company has a foward P/E ratio of 20 with annual earnings expected to grow at 10 percent per year on average, its PEG ratio is 2. The higher the PEG ratio, the more relatively expensive the stock is. As with other measures, the PEG ration should be used wiht caution. PEG relies on two different estimates: next year's earnings and five year earnings growth and is doubly subjected to overly optimistic or pessimistic estimates. It also breaks down at zero growth or hyper growth companies.

Price to Sales Ratio

The price to sales ration(P/S) is figured the same way as the P/E, execpt with the company's sales as the denominator and not the earnings. An advantage to using the P/S ratio is that it is based on sales a figure that is much harder to manipulate and is subject to fewer accounting estimates than earnings. Also because sales are more stable than earnings, P/S can be a good tool for screening cyclical companies and other companies with fluctuating earnings patterns.

P/S= (stock price) / (sales per share) = (market capitalization) / (total sales)

When using the P/S ratio, a dollar of earnings has the same value regardless of the level of sales needed to create it. Meaning a dollar of sales is worth more at a highly profitable company than at a company with narrow profit margins. This means that comparing price/sales generally only useful when comparing companies in the same industry.

To understand the difference across industries, let's compare a grocer with a medical device maker. Grocery stores tend to have very small profit margins, earning only a few pennies on each dollar of sales. They tend to have a P/S of 0.5. It takes a lot of sales to make one dollar so investors do not value those sales dollars highly. On the other hand a medical device maker, has very fat profit margins. A medical device maker P/S is 5.0. A grocer with a P/S of 2 would look quite expensive, while the device maker with a P/S of 2 would look like a bargain.

Price to Book Ratio

Another common valuation is the price to book ratio P/B which relates a stock's market value with its book value (also known as shareholder's equity) from the latest balance sheet. Book value can be thought of as what would be left over if a company shutters operations, pays off its creditors, and collects on its debts and liquidates itself.

Book Value Per Share = (total shareholder's equity) / (shares outstanding)

P/B = (stock price) / (book value per share) = (market capitalization) / (total shareholder equity)

As with other ratio we have covered so far, there are caveats to using P/B. For instance book value may not accurately measure a company's worth, espicially if the firm possess significant intangible assets like brand names, market share and other competitive advantages. The lowest P/B ratio tends to be in capital intensive industries like retail and utilities, whereas the high P/B tend to be in consumer products and phamaceuticals, where intangibles are more important.

Price/Book is also tied to return on equity (ROE), which is net income divided by shareholder's equity. Given two companies that are otherwise equal, the one with the higher ROE will have the higher P/B ratio. A high P/B should not cause alarm if the company continually earns a high return on equity.

Price to Cash Flow Ratio

The price/cash flow is not commonly used or well know as the other ratios that we have discussed. It is calculated similar to P/E, execpt it uses operating cash flow as the denominator instead of using net income as the denominator.

P/CF = (stock price) / (operating cash flow per share)

Cash flow can be subject to accounting shenanigans than earnings because it measures actual cash flow, not paper or accounting profits. P/CF can be helpful for firms which can have more cash flow than reported earnings.

Dividend Yield

There are two ways to make money off of a stock. When the price goes up and dividend payments. Dividend yield is an important measure of valuation. The dividend yield is the company's dividend divided by the company's share price. If a company pays an annual dividend of $5 per share and has a share price of $100 then the dividend yield is 5%. If the same stock fell to $50 a share then the yield would 10%. Conversely, the dividend yield falls when a stock's price goes up.

Dividend Yield = (per share dividend)/ (stock price)

Stocks with high dividend yields are mature companies with few growth oppurtunities.

The Financial Reality

We've gone over how to calculate a lot of ratios. Understanding the components of these ratios is key to learning the lingo of investors. It is also essential in beginning to understand when a stock is cheap or expensive. The good news is that if you invest long enough, the ratios that we have discussed will be second nature.

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