Throughout the pandemic, I have been getting tons of questions from friends about stocks and whether company XYZ is a good investment. So I decided to make this quick guide for my non-finance people who are trying to figure out whether a company is sound financially.
This is for people who are interested in analyzing a company and not just YOLOing what’s trending on Twitter or r/wallstreetbets.
I will try to keep this as simple as possible so a few generalizations may be made. We will take a look at 5 key metrics that focus on the profitability and overall financial health of the company.
There are a ton of financial metrics and you can easily go down a rabbit hole but it ultimately comes down to what YOU think is most important for a company’s success. As you invest, you will begin to develop what a successful company looks like to you. If you’re interested in more ratios, WealthyEducation has a good list.
- EARNINGS PER SHARE (EPS)
Earnings per share (stock) is very straightforward. It is the company’s profit divided by the amount of shares that are in the market. We use this measure to see if the company is profitable. If the EPS is negative, that means the company suffered a net loss.
The higher the Earnings per Share (EPS), the better.
Net Income (profit) = $10,000
Outstanding Shares = 2,000
EPS = $10,000 / 2,000 = $5.00
- PRICE TO EARNINGS RATIO (P/E)
The price to earnings ratio is also another profitability measure. It divides the current stock price by the company’s EPS. If a company does not have a P/E ratio listed, then it does not produce a profit.
The P/E ratio indicates how much you are willing to pay for every $1 in earnings.
- P/E ratio of 20 – you are willing to pay $20 for every $1 of profit
- P/E ratio of 50 – you are willing to pay $50 for every $1 of profit
With that logic, it would make sense that a lower P/E ratio is better because you would make a $1 return with less money invested. A low P/E ratio can indicate that a company is undervalued and a high P/E ratio can indicate that a company is overvalued. A higher P/E ratio can also indicate that investors expect the company to perform better in the future for whatever reason.
Now you might be thinking, “I could just look at P/E ratios alone to make a decision”. That is not the case because P/E ratios do not take into account anticipated growth of the company or debt the company currently carries so take the P/E ratio with a grain of salt.
There is no hard rule for what constitutes a good P/E ratio. Some say under 20, some say under 50, I will let you do that research and make your own decision but it does help to research ratios compared to others in the industry.
I’d say a Price/Earnings (P/E) ratio lower than competitors is better.
Stock Price: $100
Price to Earnings Ratio = $100/$5 = $20
- CURRENT RATIO
Before we get into the current ratio, we need to define “assets”, “liabilities”, and “liquidity”.
What are assets? An asset is something owned by the company that has value
Examples: Cash, Accounts Receivable, Inventory, Property, Equipment
What are liabilities? A liability is a debt owed by the company
Examples: Accounts Payable, Building Lease, Salaries Payable, Mortgages Payable
What is liquidity? Liquidity refers to how fast an asset can be bought or sold or turned into cash. It would be faster to sell an iPhone than it would be to sell a house. So an iPhone would be considered more liquid than a house. That is the general gist of liquidity. It is important because without cash, or the ability to obtain it quickly from your assets, you cannot continue to operate if there is a financial bump along the way.
The current ratio is a liquidity metric that shows a company’s ability to meet their short-term obligations (liabilities). Short-term typically refers to within 1 year. Generally, having a current ratio of over 1 is good because it means you have more current assets than current liabilities but, as always, it is good to compare the company to others in the industry.
The higher the Current Ratio, the better.
Current Assets = 15.0
Current Liabilities = 3.0
Current Ratio = 15.0 / 3.0 = 5.0
- DEBT TO EQUITY RATIO (D/E)
D/E ratio is a leverage ratio. Leverage refers to using borrowed money for an asset. A mortgage loan would be considered leverage as it allows you to buy something you wouldn’t be able to afford in cash today but will be able to pay back over time. Businesses commonly use debt to fund business efforts.
Equity is the difference between assets and liabilities. Investoepdia has a good description of shareholder’s equity:
“Shareholders’ equity is the amount of money a company could return to shareholders if all its assets were converted to cash and all its debts were paid off.”
The D/E ratio divides all of the liabilities over the equity. It lets you know for each $1 of equity, this is how much debt you have.
The lower the Debt/Equity ratio, the better.
D/E ratio = 4.0 / 2.0 = 2.0
- RETURN ON EQUITY (ROE)
ROE measures how effectively a company can generate profits with the money that’s invested. It takes net income divided by equity. There is no set rule for an ROE percentage but the higher the better. I personally look for companies with an ROE of around 15%+.
The higher the Return on Equity (ROE), the better.
Net Income: $10,000
ROE = $10,000 / $50,000 = 20%
EXAMPLE USING YAHOO FINANCE
You can use Yahoo Finance to find all of these metrics. I will use Walmart ($WMT) as an example. We only need 2 of the tabs on Yahoo Finance: Summary and Statistics.
On the summary page, you will find the PE Ratio and EPS. TTM means trailing 12 months which is updated on a quarterly basis.
- Walmart is profitable
- They earn $6.27 per share
- Investors are willing to pay $24.02 for every dollar of earnings
- Walmart is able to generate 22.90% on what the shareholders have invested
MRQ = Most recent quarter
- Current Ratio is less than 1 which means they have more current liabilities than current assets. The preference is that this number is at least 1 or more.
- Debt/Equity Ratio – at a first glance, it is hard to tell if this number is good or not. We will take a look at a competitor to compare: Target ($TGT). Target currently has a Debt/Equity Ratio of 133.23 which is higher than Walmart’s 86.51. This mean’s Walmart may be in a good spot for the industry average. Of course, we could look at more stocks like Costco or Kroger to get a better idea.
Walmart has a good handle on generating profits and ,after taking a look at a competitor, they have a good handle on their debt compared to industry.
From doing this quick search, you can get an idea of whether any company is strong financially or it’s a YOLO play. A lot of times, this leads to more questions/research which will help you learn more about the company and its business. Hope this helped teach you some new things and good luck on your trading journey!