Key Ratios
Value investing research involves analysing ratios derived from a company’s financial statements, providing insights into crucial aspects such as liquidity, profitability, growth, earnings quality, and sustainability. Conducting financial analysis through ratios is a pivotal step in fundamental analysis, the process of determining a stock’s fair value.
Navigating this analysis might seem challenging, given its association with complex corporate reports and obscure accounting terminology. The GWV Company Analysis Spreadsheet simplifies this process by automatically retrieving financial information and computing key ratios.
In the following sections, we break down the calculation of these ratios and explain how they contribute to our comprehensive understanding of a company’s fundamental value.
Market Value per Share [latex]\div[/latex] Earnings per Share
This very common measure is the amount investors are prepared to pay for $1 of earnings. So, a P/E of 20 means that investors are paying 20 times earnings to own the stock.
Historically P/E ratios have averaged between 14 and 16.
A low P/E ratio might mean that the company is undervalued, and equally might mean that investors see a reason to not pay so highly for it.
A high P/E might mean that a stock is overvalued, or that investors see higher potential earnings in the future. It might also mean that investors are willing to pay a premium for a reliable and safe stock even if it is not a growth stock
Price per share [latex]\div[/latex] Book Value per share
The Book Value is the total assets less liabilities less intangible assets, so the ratio is how much are investors willing to pay for $1 of net assets.
The lower the better, and generally a value under 1 is good.
Price per share [latex]\div[/latex] Sales per share
How much are investors prepared to pay for every dollar of sales.
The Enterprise Value is not a ratio, but a measure that is used in the calculation of ratios. It is considered to be a more meaningful measure of the company’s total value than market capitalization.
The formula is Market Captalization (shares x share price) + Total Debt – Cash and Cash Equivalents
This is an estimate of the aquisition value of a company because if you buy all the shares to own the company, you will also receive the debt (a liability to repay), and also the cash.
Enterprise Value [latex]\div[/latex] Revenue
How successfully is the company using its resources to generate revenue.
Considered to be a good range between 1 and 3. Higher suggests it is overvalued and lower undervalued.
This ratio is also useful in analysing companies that are not yet generating income or profit.
Enterprise Value [latex]\div[/latex] EBITDA
Compares the value of a company to its earnings, so how much is the company generating compared to the net financial resources invested.
Given that taxes are excluded it is suitable for cross-national comparisons.
A low ratio compared to its peers might indicate that the company is undervalued.
The percentage by which revenue increases (or decreases) over time.
A business should grow its revenues over time to keep pace with inflation and as a result of efficiently reinvesting past profits.
If revenues are falling, eventually the company will become unprofitable.
Current Assets[latex]\div[/latex] Current Liabilities
A liquidity ratio measuring he ability of a company to pay off its short term liabilities within a year.
A company that does not have the resources to pay off its upcoming debts may be in distress or putting itself in a vulnerable position.
Current ratios should be compared within an industry, but generally a value below 2 is considered adequate.
Total Debt[latex]\div[/latex] Total Equity
A key gearing ratio that measures the company’s relative reliance on debt as opposed to equity for funding.
Debt on the balance sheet is not neccessarily a bad thing as it may be used to fund expansion or income generating activities.
However debt must also be serviced, and in an economic downturn, a rising interest environment, or other situation leading to a decrease in revenue it becomes a drag on the company’s profitability and a the extreme can threaten its ability to continue operations.
A D/E ratio higher than its peers might indicate that a company has taken on greater risk, and as a rule of thumb should not be above 2.
ROIC = NOPAT (= Operating Income *(1- Tax Rate))[latex]\div[/latex](Equity + Debt – Cash and Equivilents)
How well is the company putting its capital to work.
The higher the better. A good return varies across industries.
Income[latex]\div[/latex]Equity.
Equivalent to a return on net assets.
Like all measures of return it depends on the economic environment and the industry, but should take into account the risk free rate, inflation, and risk premium.
Dividend per Share[latex]\div[/latex] Price per Share
The cash return in the form of dividends that an investor receives for purchasing a share in the company.
Established and slow growing companies tend to pay more in dividends as they have less opportunity to invest in growth and expansion.
A high dividend yield may not necessarily mean an attractive investment as the dividend may not be sustainable (or even paid from debt), as the company may have problems meaning that future profitablity is compromised (declining market share, high debt, litigation etc).
In this case the high yield would be because the price component of the formula is low as investors do not find it an attractive investment.
The dividend growth rate is the annualized change in dividends over time.
A growing rate indicates a profitable company so long as those dividends are paid out of profit (see the Dividend Coverage ratio)
Income investors value a consistently growing dividend as their income streams become more reliable.
The dividend growth rate is also used in stock valuation models.
Net Income[latex]\div[/latex] Dividends Paid
A measure of how comfortably a company can afford to pay its dividends.
>2 is good, consistently below 1.4 may be a cause for concern.
The inverse of the Dividend Coverage Ratio, the Payout Ratio, is Dividends Paid divided by Net Income, so, the percentage of income paid out to shareholders. As such 50% or less is good, and anything greater than 70% is getting high.
Any Questions?
Don’t know where to start? Need assistance navigating the site? We are here to help.