Welcome to the third part in the intermediate guide to investing! By now, we have learnt the importance of reading company reports, and we also have a preliminary understanding of company's financial statements and the key metrics within them.
If you haven't yet read our beginner's guide to investing, where we introduce things like why you should invest, how to start investing, risks, rewards and strategies, do check it out first!
Chapters in this guide:
Part 1 - Why Read Financial Statements?
Part 2 - How To Read Financial Statements
Part 3 - 10 Key Financial Ratios & Metrics
Part 4 - How To Analyze A Stock
Part 5 - Portfolio Management & Asset Allocation
Part 6 - Portfolio Rebalancing & Market Conditions
Resource - Stock Analysis Checklist
As mentioned previously, reading through the entire financial statements and reports, while recommended, is extremely time consuming. Luckily, there are many sources which provide condensed versions of a company's financial statements.
These may even included more detailed information about a company. These values do not appear in the financial statements, but are calculated based on financial formulas.
While we will not we teaching you how to calculate these information yourself (you'll probably need a full accounting course to learn it), we will be introducing the key performance metrics of a company and what they mean.
In this part, we will examine Microsoft's key financial ratios as provided by Yahoo Finance, introduce each one and point out which you should be looking out for. These indicators provide a comprehensive overview of a company's financial health, and are useful in deciding if you want to invest in a company. Let's begin!
What are key financial indicators?
Key financial indicators are basically financial statistics calculated about a company that provide important information about a company's finances. This can help investors make more informed decisions.
As mentioned in the previous part of this guide, an important drawback about reading financial statements yourself is that we cannot make decisions simply based on one part of the financial statement.
This could mislead you into thinking a company is doing well, when it could be performing otherwise. Key financial ratios help in this by combining various parts of the financial statements to draw conclusions.
For example, it could check the company's cash holdings in the cash flow statement, and tally that against the current liabilities of the company in the balance sheet. In this way, we get a clearer view of whether a company is able to pay off its liabilities in the short term.
This is just an example of a key financial metric. Nowadays, many websites provide automated generation of key financial metrics for investors to use.
Let us look at some key financial ratios taken from Yahoo Finance about Microsoft. You can find the data here.
5 important financial ratios
First, let us start by looking at a few important financial metrics that every investor should glance at when evaluating a company's financial health. They are:
- Current ratio
- Debt to equity ratio
- Price to book ratio
- Price to earnings-to-growth ratio (PEG)
- Payout ratio
Let us go through these 5 key ratios one by one.
Firstly, we have the current ratio. The current ratio measures the ability of a company to pay off its liabilities that are due within a year. It can be calculated as follows:
Current assets / Current liabilities
This is a calculated ratio from the balance sheet. As you can see from the formula, it measures whether a company has enough current assets (things it owns, including cash and cash equivalents) that can be converted to cash within a year to cover its current liabilities like debt and payments.
A current ratio above 1 means that the company can fully cover its current liabilities and a current ratio below 1 means that the company might struggle to pay off its liabilities within a year, which is a huge warning sign.
From Yahoo Finance, we can see that Microsoft's current ratio (as of the writing of this article) is 2.90. This means that their current assets can cover their current liabilities by 2.9x, which is a very good sign that they are doing very well financially.
There is a more conservative version of the current ratio, known as the quick ratio.
The quick ratio uses only the most liquid current assets, unlike the current ratio which uses all current assets. This means things that can be easily and surely converted to cash, like cash itself, short term market securities (e.g. bonds) and account receivables (money it expects to receive shortly).
This does not take into account other current assets like inventory, supplies and prepaid expenses (services the company has paid for but yet to receive), as these assets might not be able to be converted back to cash quickly. This is because inventory may not be sold, and services may not be refunded etc.
Therefore, by using only the most liquid current assets in its calculation, the quick ratio measures a more conservative version of a company's ability to pay off its current liabilities. As usual, we are looking for a ratio of above 1 to ensure that a company is in good financial health in the short term.
An important drawback to note while looking at the current ratio and quick ratio is that it does not account for long term debts and liabilities. Sure, a company may have enough to cover its liabilities in the short term, but it may not be the case in the long term.
It is difficult to determine a company's financial health in the long term, since its ability to repay its liabilities in the long term depends on a lot of factors like how much it can grow, how much it can earn and such.
Hence, it is important to keep in mind that one cannot simply look at the current ratio alone as it is a short term myopic view of a company's financial health.
Debt to equity ratio
Next, we have the debt to equity ratio. When a company wants to raise money for itself, it can generally do so in two ways. First, sell some of its issued shares to raise money from investors. Second, take on leverage (debt) by loaning from a bank or some other entity.
The debt to equity ratio measures how a company raises funds for itself. Its calculation is:
Total liabilities / (Total assets - Total liabilities)
- OR -
Total liabilities / Shareholder's equity
This can also be found in the balance sheet and calculating a little. Remember how shareholder's equity is the amount leftover after a company takes all its assets and pays off all its liabilities. It's also known as the amount left to investors after the company pays off all its liabilities.
The debt to equity ratio measures how much a company is financially leveraged. If the debt to equity ratio is high, say >1.5, then the company might be taking on too much debt to finance itself instead of getting money from investors.
A high debt to equity ratio may show that the company can struggle to pay off interest in the future, having debt repayments cut into its future earnings.
On the other hand, a low debt to equity ratio <0.5 may show that the company is not taking on enough debt. Debt may not always be a bad thing. If we take on a loan with an interest rate of 5%, but we get returns at a rate of 10%, it means we are making an extra 5% of income on that loan.
Without the loan, we might not be able to increase our earnings, but if we take a loan, we will increase our income by 5%. Therefore, this is a "good debt", since if we take it, we actually increase our earnings.
Hence, it's a balancing act for a company. Ideally, a company should try to take on as much debt as it can to grow itself and its earnings. However, if they take on too much debt, it could result in them being unable to repay their liabilities. Companies must balance between the right amount of debt to grow themselves.
Note that the debt to equity ratio really depends on the individual company. Companies may have a high debt to equity ratio, but it could mean that it is mostly good debt if their earnings are growing superbly.
For example, Microsoft has a debt to equity ratio of around 2.09 (as of this article), which seems pretty high. Yet, investors are still flocking into buying the stock due to Microsoft generating great earning returns.
Therefore, we can make a preliminary conclusion that Microsoft can afford to fund themselves mainly through debt instead of investors since they are generating good returns on their loan amounts. In such a case, the high debt to equity ratio is fine.
In many cases, a high debt to equity ratio requires you to scrutinize the company carefully for anomalies.
Price to book ratio
Many investors also like to look at the price to book ratio as it hints as to whether a company is overvalued or undervalued.
The book value of a company is how much a company is worth on paper. This means the collection of all its tangible assets (aka no goodwill, brand name etc.), and is how much the company actually owns physically.
The price is simply how much investors feel the company is worth, which is basically the share price.
The price to book ratio is calculated as:
Share price / Book value per share
If the price to book ratio is above 1, it means that investors value the company higher than its actual physical worth. This could be due to the company's earnings being projected to be great in the future, or the company could be overvalued, making it a risky buy.
Conversely, a price to book ratio below 1 either means that a company is undervalued, or that investors have no confidence in a company's state right now. Either way, caution is required.
From Yahoo Finance, we see that Microsoft's price to book ratio is at a whopping 11.90. That sounds way overvalued! Yet, Microsoft's stock price has been increasing steadily over the years.
This shows that while Microsoft is possible overvalued, investors still have great confidence that Microsoft will continue to flourish and grow in the future.
Actually, the price to book ratio can be misleading in some cases, such as in the case of Microsoft. It is important to note that Microsoft is a software company, based off things like Windows systems, enterprise software like Microsoft Teams and Microsoft Azure as a cloud hosting company.
Since most of its earnings come from digital products, it is understandable that they would not have as much physical assets as other companies like automobile makers or companies that sell physical products.
Therefore, on the surface, the book value of the company could be low, while its earnings and hence its valuation could be high, resulting in this absurd price to book ratio.
Of course, it could also mean that a company is vastly overvalued. After all, Warren Buffet himself says in his recent annual letter that:
Prices are sky-high for businesses possessing decent long-term prospects.
The market could be very overvalued right now, too. It is up to your knowledge of the company's fundamental business and your prospects for the company to determine if a company is overvalued or undervalued instead of just glancing at the price to book ratio.
The price to earnings-to-growth ratio measures the stock price now compared to the projected earnings of a company in the future.
Similar to the price to book ratio, it can give you a hint as to whether a company is overvalued or undervalued. The only difference is that it is based on the earnings of a company, and not the book value (assets).
You might have noticed there is also a P/E ratio, the price to earnings ratio. The P/E ratio is basically the share price divided by the earnings per share of a stock.
Often, when investing in a company, we are more interested in its future prospects than its current prospects. The PEG ratio improves on the P/E ratio by taking into account future earnings growth in its calculation.
The PEG ratio is calculated as follows:
P/E ratio / Growth of earnings per share
(Share price x Growth of earnings per share) / Earnings per share
As you can see, the PEG ratio takes into account how the earnings per share will grow. As such, it is a measure of whether a company's share price is overvalued or undervalued as compared to its expected future earnings and growth.
A high PEG ratio above 1 means that the company might be overvalued for the amount of earnings it's expected to have, and below 1 might mean that a company is undervalued, or lacking in investor's confidence.
In Yahoo Finance, we see that the PEG Ratio is projected for 5 years of expected earnings. Microsoft's PEG Ratio is 2.19, hinting that its share price is overvalued for the earnings it has.
The PEG ratio is a fairer comparison than the price to book ratio, since it takes into account the earnings of a company, which is a concrete amount rather than the variable book value of a company.
However, note that the PEG ratio is a projected ratio and hence may be more inaccurate than the price to book ratio, which relies on concrete assets. It also fails if the company has low growth, hence giving a low PEG ratio.
While a company may have low growth, it may have good dividend payouts and stable earnings. Therefore, you cannot solely rely on the PEG ratio to make a decision.
A key point to note while using the PEG ratio and the price to book ratio is that you should only compare companies of the same industry type when using these ratios. For example, if you are evaluating a software company, you should compare it to another similar software company to see if one is overvalued or undervalued.
The best thing to do is to search up industry averages for comparison. You can then benchmark the company based on the industry standard.
Lastly, we have the payout ratio. This ratio mainly deals with dividends for the value investor. It measures the amount of dividends paid out as compared to a company's free cash flow.
The formula is simply:
Dividends paid / Cash Flow
You can find the ratio in Yahoo Finance under the dividend yield section if a company pays out dividends.
The payout ratio is important for dividend investors. As mentioned, companies without high growth will tend to choose to pay dividends instead to continue attracting investors with their profits.
The payout ratio represents what percentage of a company's free cash flow (the amount of spare cash a company has after paying all it's capital expenditures) paid out as dividends.
If the ratio is under 1, then the company is paying out a healthy amount of dividends and it can afford to do so in the near future.
If the ratio is above 1, then the company is paying out more dividends than it can support with its cash holdings. Therefore, the company will have to take on debt in order to continue paying the same amount as dividends in the last quarter. The company may even reduce or cut its dividends.
This is an important ratio to lookout for if you are investing for dividends.
5 important financial metrics
Let us also look at some important financial metrics to take note of while evaluating a company's financial health.
- Free cash flow
- Return on equity
- Moving average
- Earnings per share
- Dividend yield
These financial metrics do not mean much on their own. They require you to compare them against previous year's or quarter's metrics to see if they are growing or shrinking.
Free cash flow (FCF)
The amount of cash a company has leftover after paying for its operating expenses and capital expenditures (basically, money spent on creating its products, selling them and growing the company).
In essence, what's leftover is the amount of cash that a company is free to use for whatever purpose it wants, usually paid out as a dividend, or a share repurchase. Both of these increase share value, and is much welcomed by investors.
You always want to see a positive number for the free cash flow, and it should ideally be growing year over year. Above all, it should be stable.
Of course, a business might choose to expand or increase operations, causing the free cash flow to drop. A temporary drop is okay, a long term one is not.
A positive and growing free cash flow means that the company can grow and provide value to its investors stably.
Return on equity (ROE)
Return on equity measures how much value a company provides its investors. Since equity is the amount of money invested into the company by investors, return on equity measures the amount that the company made versus how much investors had to put in.
It is calculated using:
Net income / Shareholder's equity
The return on equity shows how effectively a company utilizes the resources coming in from investors. A good ROE is generally around 15-20%, meaning that a company is putting investor's resources to efficient use.
An ROE lower than 15% could mean that there are better opportunities abound.
Microsoft's return on equity is at a whopping 44.20%. This means that they provided returns of up to 45% on whatever investors put into them!
Another thing investors take note of is the moving average of the share price. Moving average is usually calculated in 50 day and 200 day windows, giving the average share price for that period.
A favorite indicator is to see if the 50 day moving average is higher than the 200 day moving average. If so, it could mean that the share price will increase in the near future, and vice versa.
However, this is obviously not an extremely scientific method and has no guarantees. Always do your own research using other financial data and your own understanding of the company and it's future growth.
As such, you can simply regard the moving average as a sort of baseline to price your own expectations as to where to buy and sell your shares.
Earnings per share (EPS)
This is one of the important financial metrics that investors look at. This basically shows the amount of profit a company makes per outstanding share.
A high earnings per share means that a company is generating good profit for investors, and vice versa.
Generally, we want earnings per share, revenue and net income to all be positive and increasing year over year for a company to be financially healthy, although there could be decreases due to expanding or growth efforts.
For dividend investors, other than checking the payout ratio, make sure to check the dividend yield. This shows the percentage return you can expect to get, and is calculated by taking:
Dividend per share / Share price
If a company has a low growth in share price due to lacking growth, most of its returns are probably paid out as dividends instead of trying to expand the company. Therefore, dividends are where your main returns will come from.
For value investors who love dividends, you obviously want a high dividend yield. That said, an extremely high dividend yield is obviously not sustainable, so be sure to check the payout ratio as well.
You don't want a company having to cut or reduce dividends, which can cause its share price to fall drastically.
Generally a dividend yield anywhere from 4-6% is generally stable. Any higher and it could be risky, any lower and the company is probably focused on growth.
In this part, we introduced 10 important financial ratios and metrics to get a general overview of a company's financial health. As you get more familiar with these metrics, you can quickly glance over companies and determine their general financial stability.
Of course, these 10 metrics are not exhaustive, nor comprehensive. There are many other financial metrics to take note of. As always, you will have to do some of your own homework to see if a company is good to invest in.
Do note that numbers are just numbers - they do not provide a prediction of the future. When investing in a company, the most important thing is in understanding the company's fundamentals and checking its business model yourself.
In part 4 of our intermediate guide to investing, we will look into analyzing a stock's strengths and weaknesses, and corroborate our findings with analysts' reports to supplement the information that financial data can give us.
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