Researching a stock before buying it may seem like a time-consuming process, but any veteran investor would agree it is time well spent.
Looking into a company's operating history and industry environment may just as well be the difference between reaping significant gains or avoiding future losses.
Newbie investors are often tempted to give up when they are bombarded with a series of technical jargons when deciding to invest in the stock market.
Researching a stock before buying it may seem like a time-consuming process, but any veteran investor would agree it is time well spent.
Although they may seem quite tough to grasp at first, as we gradually go through them now you will realize it’s not as hard as it seems.
Before we list out what some of these metrics are, it is important to know what it means to understand a company’s profitability, valuation and liquidity.
Profitability and liquidity signal financial strength or weakness, while valuation indicates good buying and selling opportunities. Most ratios or indicators can be broadly categorized under these broad concepts, so it will help to get a clear grasp of them.
Understanding profitability
A company's gross, operating and net profits indicate how efficiently it converts revenues to the bottom line.
For example, if a company has increased its advertising expenditures to launch new products or expand into new markets, its sales should increase proportionately. If not, profitability and cash flow will suffer. When researching stocks, look for companies that manage to grow their margins each year.
Importance of valuation
Without knowing the proper value of stocks, investors are hard-pressed to find the right time to buy or sell shares. A stock's market value fluctuates throughout the course of a trading session based on the supply of shares coupled with investor demand.
The market value lets an investor know whether shares are currently affordable and whether it is worth buying now to help make a profit on a later date.
Without knowing when a stock is too richly priced, or over-valued, an investor may miss out on an opportunity to cash-in on an investment and profit. What's even worse, an investor might wind up owning a stock with a price that has nowhere to go but down.
By not knowing when a stock is too richly priced, or over-valued, an investor may miss out on an opportunity to cash-in on an investment and profit. Worse, an investor might wind up owning a stock with a price that has nowhere to go but down.
By locating stocks in the market that are under-valued or priced below where they are worth based on certain metrics, investors can seize an opportunity to earn profits.
Knowing company liquidity
Liquidity simply means having enough cash on hand for the company’s operations and strategic initiative.
The statement of cash flow provides clarity. A company's statement of cash flows shows the cash inflows and outflows for each reporting period. Companies that drive revenue growth while managing costs generate steady cash flows.
This is an important performance metric when researching stocks because liquidity gives management the flexibility to invest in research and development, expand into new markets or plan takeovers.
We will look at in detail what is the major metric to look for when looking at n a cash flow statement, and therefore understand a company’s liquidity strength.
Glossary of key measures of stock strength
Now, here is a list of profitability and valuation measures to keep an eye out in a company’s balance sheet or any research firm’s stock analysis. We will look through this list in detail, with examples to show how it’s calculated.
But keep in mind that while these ratios can help you assess the value of a stock and its growth potential, there are many other factors affecting stock prices that can’t be easily measured.
• Earnings per share (EPS)
This is the amount each share would get if a company paid out all its profit to its shareholders. EPS is calculated by dividing the company’s net profit by the number of shares.
EPS can tell you how companies in the same industry compare. Companies that show steady, consistent earnings growth, year after year, will often outperform companies with volatile earnings over time.
The formula is: EPS = Net profit / number of shares
• Price to earnings (P/E) ratio
This measures the relationship between the earnings of a company and its stock price. It’s calculated by dividing the current price per share of a company’s stock by the company’s earnings per share.
The P/E ratio can tell you whether a stock’s price is high, or low, compared to its earnings. If a company has a high P/E, investors are paying a higher price for the stock compared to its earnings, because of growth expectations in the future.
If a company has a high P/E, investors are paying a higher price for the stock compared to its earnings, because of growth expectations in the future.
If a company has a lower P/E, you get more earnings for your investment. This makes a low-P/E stock a good value, but it can also simply indicate that investors aren't very confident about the company's prospects.
How do you know? You’ll likely have to look at other indicators before you decide.
The formula is: P/E Ratio = Share Price / EPS
• Price to earnings ratio to growth ratio (PEG)
This helps you understand the P/E ratio a little better. It’s calculated by dividing the P/E ratio by the company’s projected growth in earnings.
The PEG can tell you whether a stock may or may not be a good value. The lower the number, the less you must pay to get in on the company’s expected future earnings growth.
The formula is : PEG Ratio = P/E Ratio / Forecasted EPS growth rate
• Price-to-sales ratio (P/S)
The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price) and divide it by the company's total sales or revenue over the past 12 months.
The lower the P/S ratio, the more attractive the investment. The general rule of thumb for P/S ratios is that anything below 0.75 is a sign of fair valuation or undervaluation, while anything above 3.0 is overvaluation.
This would mean that the sales per share is Dh4.55 (Dh455 million in sales / 100 million shares outstanding). Which implies a P/S ratio of 2.2 (Dh10 share price / Dh4.55 sales per share).
The formula is: P/S Ratio = Share Price / Sales per Share
• Dividend payout ratio (DPR)
This measures what a company pays out to investors in dividends compared to what the stock is earning. It’s calculated by dividing the annual dividends per share by the EPS.
The DPR can give you an idea of how well a company’s earnings support the dividend payments. More mature companies will typically have a higher DPR.
More mature companies will typically have a higher DPR.
They believe that paying more in dividends is the best use of their profits for the firm and its shareholders. Since growing companies are likely to have less or no earnings to pay out dividends, their DPR would tend to be low or zero.
The formula is: Dividend Payout Ratio = Dividend Paid per Share / EPS
• Price-to-book value ratio (P/B)
This compares the value the market puts on a company with the value the company has stated in its financial books.
It’s calculated by dividing the current price per share by the book value per share. The book value is the current equity of a company, as listed in the annual report, which is nothing but how much the company has in assets minus its liabilities.
Most of the time, the lower the P/B is, the better. That’s because you’re paying less for more book value.
If you’re looking for a well-priced stock with reasonable growth potential, you may want to use a low P/B as a tool to identify possible stock picks.
Book value per share is calculated subtracting total liabilities from total assets and then dividing it with the number of shares outstanding. P/B Ratio is calculated by then dividing the current share trading price with book value per share.
If there are 10 million shares outstanding, book value per share is Dh2.5 (25M/10M) – meaning each share would represent Dh2.50 of book value.
If the share price is Dh5, then the P/B ratio would be 2 (5/2.50). This illustrates that the market price is valued at twice its book value.
The formula is: P/B Ratio = Share Price / Book Value per Share
• Dividend yield
This measures the return on a dividend as a percentage of the stock price. It’s calculated by dividing the annual dividend per share by the price per share.
The dividend yield can tell you how much cash flow you’re getting for your money, all other things being equal.
The formula is: Dividend Yield = Annual Dividend / Share Price
• Current ratio:
The current ratio, or working capital ratio, is a key liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations. It compares a firm's current assets to its current liabilities.
A company’s current ratio, which is an indication of a firm's liquidity, is calculated by dividing current assets divided by current liabilities.
A current ratio greater than 1 usually means that a company has enough liquid assets to pay its bills. A ratio under 1 indicates that the company’s debts due in a year or less are greater than its assets (cash or other short-term assets expected to be converted to cash within a year or less.)
The higher the current ratio, the more capable a company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities.
However, while a high ratio, say over 3, could indicate the company can cover its current liabilities three times, it may indicate that it's not using its current assets efficiently, is not securing financing very well, or is not managing its working capital.
To calculate the ratio, analysts compare a company's current assets to its current liabilities.
Current assets can be found on a company's balance sheet and represent the value of all assets it can reasonably expect to convert into cash within one year.
Current liabilities are a company's debts or obligations that are due within one year, appearing on the company's balance sheet.
Similarly let’s say Company B has Dh15.89 million in current assets and Dh19.6 million in current liabilities, the current ratio of Company B would be 15.89/19.6, which equals 0.81.
This shows that Company A had more than enough to cover its current liabilities if they were all theoretically due immediately and all current assets could be turned into cash. For every Dh1 of current debt, Company B had just enough (98 fils) available to pay for the debt, in a similar scenario.
The formula is: Current Ratio = Current Assets / Current Liabilities
