When deciding to buy stocks from a certain company, the amount of numbers, ratios and percentages to consider can be quite daunting. There is an overabundance of financial information available for every listed company. However, any investor wanting to buy the best stocks for the lowest price will have to research the financial situation of his potential investment to some degree. Two tips from Warren Buffett can already make the decision easier: invest only in what you understand and don’t put money in companies with bad reputations. Aside from this however, it can’t hurt to at least look at some figures before buying stocks. This article will cover the five (or actually six) most important figures and ratios to consider when buying stocks.
Equity Ratio = Total Equity / Total Assets
A company’s equity ratio is a solvency ratio which shows the ability of the company to meet it’s long term debts. It shows if the company is able to stay in business or not. The higher the equity ratio of a company, the better. Absolute limits for the equity ratio cannot be given, because it depends on the industry what is considered to be a healthy equity ratio for a given company.
Return on equity (ROE)
ROE = Net Income / Shareholder Equity
Return on equity or ROE measures the profitability of a given company. Net income should be measured over the full fiscal year to make this ratio usable. Sometimes it’s better to average the ROE over several years to get a better long term perspective on the profitability of a given company. The higher the ROE, the more profitable the company is.
Earnings per share (EPS)
EPS = Net income / Average Outstanding Shares
Earnings per share or EPS measures the amount of profit allocated to each outstanding share. See EPS as a piece of the proverbial pie. This means the bigger the piece: the better. EPS is usually the most important figure when trying to estimate the performance of a company compared to the past. EPS is also used to calculate the price per earnings (see next paragraph) of a given share.
Price per earnings (P/E ratio)
P/E Ratio = Share Market Value / EPS
Price per earnings or the P/E ratio measures the current price per share against the EPS of the company. The P/E ratio shows how many years it would take the company to pay back the entire investment with the same profits. Therefore a lower P/E ratio is always better. The P/E ratio is often used to describe how cheap or expensive a company’s share is. Shares with P/E ratios less than 10 are called cheap, while above 20 the shares are considered to be expensive.
Dividend Yield = Annual Dividend Per Share / Share Market Value
The dividend yield is always presented as a percentage. It indicates how much profit is payed out to share holders relative to the share price. A higher dividend yield means an investor will get more profit for the invested funds. Dividend yields can also be used to measure the health of a company by comparing it with other companies in the same sector. Sometimes dividend yields are higher than the interest rate on a savings account (especially in these times), which can be enough reason to favor shares with high dividend yields. The only problem is that dividend is never a given right, which means there is always the risk that any company might abruptly stop paying dividend to shareholders.
Extra: Intrinsic value
Measuring the intrinsic value of a company can be a useful method to estimate the value of company in the long term. For me personally it’s the single most important figure included in this article, but also the most difficult to calculate. Intrinsic value is calculated by taking the net income over at least five years in the past and projecting this over the coming years. Because calculating the intrinsic value is difficult, the subject itself warrants its own article someday. Information about calculating the intrinsic value of a company can be found in Security Analysis by Graham and Dodd or in the Dutch book De Basis van het Beleggen by Holland Invest.
One important final remark
An investor should never rely on only one of the mentioned figures and ratios in this article! All figures lose their importance when used as a single number. These figures and ratios should be used in conjunction with each other and be part of a more elaborate study on the health of a company.