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Financial Analysis: Analyze Financial Ratios For Any Stock

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Financial Analysis:

 

Analyze Financial Ratios For Every Stock

 

 

 

Andrew P.C.

 

Copyright © 2017 Andrew P.C.

 

All Rights Reserved

 

Contents

 

Introduction 4

About the author 5

Financial statements 7

Balance sheet 9

Income statement 11

Statement of cash flows 15

Gross margin 18

Operating margin 21

Net margin 22

Earnings-per-share (EPS) 23

Asset turnover 26

Return on assets 27

Return on equity 30

Accounts receivable turnover and DSO 34

Inventory turnover and DSI 37

Accounts payable and DPO 39

Cash conversion cycle 41

Liquidity analysis 42

Interest coverage ratio 44

Debt-to-equity 45

Debt/EBITDA 46

Dividend yield 48

Dividend payout ratio 50

Price-earnings ratio 52

Price/cash flow 55

Price-to-sales 56

Price-to-book 57

EV/EBITDA multiple 59

Final Thoughts 61

Financial Statement Analysis Course 62

Dividend Growth Investing Boot Camp Course 65

 

 

[] Introduction

 

Financial analysis is all about pulling data from financial statements to evaluate business performance, risk, profitability, valuation, and various trends over time.

 

In this book, you will learn how use ratio analysis to analyze financial reports. Comparing these ratios against previous years, other companies, and industry averages can tell you a lot about a business.

 

Analyzing a stock for a potential investment is no easy task. However, these financial ratios will help you make MUCH better informed decisions!

 

[] About the author

 

Hi, I’m Andrew.

 

Ever since college, I become fascinated with investing. I even got my degree in accounting and finance!

 

There’s just something amazing about having your money work for you! After college, I got my first real job as an equity research analyst (just a fancy term for someone who researches stocks).

 

Since then, I’ve been lucky enough to be exposed to many different aspects of investing. Most people I come across are scared of investing. But it’s a necessary skill to learn in order to prepare for retirement. That’s why it is my goal to teach more people about the benefits of investing!

 

Check out my website, www.DividendGrowthMasters.com to get more great (and free) content!

 

Also, check out the back of this book for some amazing deals on my online investing courses! I will personally teach you how to invest!

 

PLUS for being loyal readers, I’ll be giving away FREE BONUS CONTENT with the courses worth over $400!

[] Financial statements

 

Before I talk about financial ratios, we have to do a quick overview of the financial statements.

 

Financial statements convey the results and financial position of a business. They are the primary output used to evaluate a company’s business prospects, sales, profitability, cash flow, and various other metrics.

 

In the U.S., financial statements are prepared on a quarterly basis. In certain parts of Europe and other international countries, financial statements are only reported on a semi-annual basis.

 

There are four types of financial statements:

 

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p<>{color:#000;}. The income statement

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p<>{color:#000;}. The balance sheet

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p<>{color:#000;}. The statement of cash flows, and

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p<>{color:#000;}. The statement of stockholder’s equity.

 

Note: The statement of stockholder’s equity isn’t used too frequently in financial statement analysis. As a result, our primary focus will be on the first three statements.

 

[] Balance sheet

 

The purpose of the balances sheet is to give investors an idea of (1) what assets the company owns, (2) what it owes to creditors (i.e. debt), and (3) the capital invested (and re-invested) by shareholders.

 

The balance sheet displays all of the company’s assets, liabilities, and shareholders’ equity at a point in time.

 

Assets represent things that provide future economic benefits to a company.

 

An example of an asset would be an office building, which provides space for the company to conduct business activities. It could also be a patent, which provides intellectual property protection for inventions. An asset can even be merchandise inventory, which can be sold for a profit.

 

Liabilities are the direct opposite of assets. Liabilities represent the company’s future economic sacrifices.

 

Equity represents the capital (i.e. cash) shareholders have invested in the company plus cumulative profits that have been retained/re-invested in the business.

 

Let’s discuss the presentation of the balance sheet. The assets and liabilities on the balance sheet are often split into current and non-current classifications.

 

Current assets and liabilities are those that will be consumed, paid off, or settled within the next year. Examples include accounts receivable due from customers, merchandise inventory, or accounts payable due to suppliers.

 

In contrast, non-current assets and liabilities are those that will not be consumed, paid off, or settled within the next year. These are the long-term assets and liabilities of the business. Examples include factory production equipment, office real estate, and long-term bank obligations.

 

The reason for the current and non-current classification is to give investors a better understanding about the short-term and long-term liquidity needs of the business.

 

The balance sheet is a great way to quickly evaluate the financial health of the business.

 

[] Income statement

 

The income statement summarizes a company’s profit generating activities—meaning its sales and expenses.

 

The income statement shows revenues and expenses over a period of time. For instance, an annual income statement shows the company’s revenues and expenses from the beginning of the year until the end of the year.

 

Most companies prepare a multi-step income statement. This just means there are various subtotals for profit accounts throughout the statement.

 

This is what an income statement will look like for many companies:

 

 

Revenue (also known as sales) is the top line item of any company’s income statement. Revenue represents the sale of goods/services to customers.

 

If a company generates revenue from several different sources (i.e. service vs. products), it may decide to disclose them separately.

 

Below the revenue line is cost of inventory also known as cost of goods sold (COGS). Cost of goods sold represents the cost to acquire/produce inventory for sale.

 

For a retailer like Costco, it would represent the cost to purchase inventory at wholesale prices.

 

Services companies may not have any cost of goods sold. Instead, they will have “cost of services”, which may include expenses such as employee salaries required to provide the service.

 

Gross profit represents the difference between revenue and cost of goods sold/cost of services.

 

Below the gross profit line is all of the company’s other operating expenses. These operating expenses are needed to run the day to day operations.

 

These operating expenses include:

 

[***]Selling expenses: These are expenses incurred to generate sales such as marketing, advertising, and sales commissions.

 

[***]General and administrative expense: These are back office expenses that support the business such as costs related to accounting and financial reporting, call center operations, etc.

 

[***]Research and development expenses (R&D): These are common expenses in the technology and pharmaceutical industry. These are expenses incurred to develop new products.

 

Operating income/profit is left after subtracting all operating expenses from gross profit. This is the core income of the business (before paying interest and taxes).

 

Below the operating income line item are various other income and expense items. These are miscellaneous items such as interest income on cash in the bank or interest expense on debt outstanding. It may even include gains or losses from asset sales.

 

Income before taxes is what is left after subtracting other income/expenses from operating income.

 

Finally, net income represents income before taxes less taxes. Net income is the take home profit from the business after deducting all expenses.

 

[] Statement of cash flows

 

The statement of cash flows shows how a company’s cash balance changed over time. This is an important financial statement to focus on because it shows the inflows and outflows of cash.

 

The statement of cash flows classifies cash transactions into three categories:

 

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p<>{color:#000;}. Investing activities, and

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Cash from operating activities represents cash inflows and outflows from a company’s main business activities. This involves changes in a company’s working capital.

 

By working capital, I mean current assets and current liabilities. Remember, these are assets and liabilities that will be consumed within one year.

 

Examples of cash inflows from operating activities include cash received from the sale of goods and services to customers, interest income on cash investments, and dividends from investments.

 

Examples of outflows include purchases of inventory, employee wages, office building rent, various operating expenses, interest on debt, and of course, income taxes.

 

Cash from investing activities refers to inflows and outflows related to the purchase or sale of non-current assets. Remember, non-current assets are assets that provide benefits for more than one year.

 

Examples of cash from investing activity items include the purchase or sale of office buildings, investments in stocks/bonds, and acquisitions (or divestitures) of businesses.

 

The final section of the statement of cash flows is cash from financing activities. Financing activities relate to the external financing of the company.

 

In other words, any transactions related to debt or equity financing.

 

Inflows from financing activities include selling shares to stockholders or borrowing money from the bank.

 

Cash outflows include dividends paid to shareholders, repurchases of shares from shareholders, or repayment of the principal balance of debt.

 

The reason for the various classifications is to better understand how a business is using its cash.

 

We want to know how much it is generating from core operations, how much it is investing in long-term assets, and how much external financing is required to keep the business running.

 

If we just combined all three sections into one long statement, it would be difficult to judge the cash flow generation capability of the business.

 

Margins

 

Margin just refers to the difference between a product’s (or service’s) selling price and the cost of delivering the product/service.

 

There are three main margin ratios we’ll take a look at: gross margin, operating margin, and net margin.

 

[]Gross margin

 

Gross margin = Gross profit / Sales

 

Remember, gross profit represents revenue less cost of goods sold.

 

Gross margin represents the amount of gross profit the company generates per dollar of revenue.

 

I remembered when I learned about gross margin in my first accounting class in college. I thought it was just another formula I had to remember for the test.

 

However, I wished my professor had stressed just how important gross margin is! These days, gross margin is one of the first things I look at when evaluating a business.

 

Why is gross margin important? Well because it tells investors how much it costs a business to deliver a product or service to the customer.

 

For instance, a gross margin of 60% means that the business will earn 60 cents of gross profit for every dollar of sales.

 

Businesses with higher gross margins have some kind of competitive advantage that allows them to earn more profits relative to peers.

 

Not all gross margins are comparable. When you are evaluating gross margin here are two things to keep in mind:

 

1. First, companies in different industries will inherently have different margin profiles.

 

For instance, software businesses typically have very high gross margins (70%+), while retailers or restaurants have lower margins (<60%).

 

Hence, you should only compare margins to businesses in the same industry/peer group.

 

2. Second, not all companies define gross margin the same way. For example, in the retail industry, some companies include depreciation of store assets in cost of goods sold while others put it in selling, general, and administrative (SG&A) expense.

 

As a result, you should always check to see if gross margin is comparable among peers before you draw any conclusions.

 

[] Operating margin

 

Operating margin = Operating income / Sales

 

Remember, operating income represents gross profit less operating expenses.

 

Operating margin represents the amount of operating income generated per dollar of sales. An operating margin of 20% means for every dollar of sales, the Company generates 20 cents of operating profit.

 

Operating margin is sometimes used over gross margin because it measures amount of profits generated before accounting for interest expense (on debt) and income taxes. Obviously, taxes can vary year to year depending on deductions and changes in regulation.

 

In other words, operating margin is a great way to evaluate the true operating costs of a business.

 

[] Net margin

 

Net margin = Net income / Sales

 

Net income represents sales less all expenses (including interest expense and taxes).

 

Net margin represents how much profit the business takes home per dollar of revenue generated.

 

A net profit margin of 15%, means the business makes 15 cents per dollar of revenue generated.

 

Generally speaking, higher quality businesses will have higher net margins. This is because they have sustainable competitive advantages that allow for superior profits.

 

Conversely, lower quality businesses typically have lower margin profiles.

 

[] Earnings-per-share (EPS)

 

Earnings-per-share (EPS) is a widely used metric on Wall Street.

 

It basically measures how much profits the company generates for each share outstanding.

 

For example, if the Company has 10 shareholders who each own 1 share and it generates $10 of profit, the business generated a profit of one dollar per share ($10 / 10)!

 

There are two ways to measure share count to calculate EPS: diluted share count and basic share count.

 

Just as a reminder, shares represent units of ownership in a business that typically provide for an equal distribution of profits and dividends.

 

All pubic companies have freely tradeable shares. This means that they are traded on stock exchanges as opposed to private companies whose shares are privately traded.

 

Each share in a public company typically gives the holder one vote in shareholder matters.

 

However, shares are not the only way for stockholders to hold ownership interests in a business. Companies frequently issue stock options, restricted stock, and other equity awards to compensate executives.

 

These equity awards represent the right to receive shares and act as share dilution to current stockholders.

 

Diluted share count is a more conservative approach to calculate the number of shares outstanding. Diluted shares outstanding represents basic shares outstanding plus any other potential claims on common shares.

 

Let’s say a company has 200 shares outstanding from raising capital to start operations. At the end of the year, the company decides to compensate the CEO with 10 stock options, with each option allowing the CEO to acquire one share.

 

In this example, basic shares outstanding would be 200 shares and the diluted share count would be 200 + 10 or 210 shares.

 

The most common way to utilize share count in financial analysis is to express a company’s earnings on a per-share basis.

 

This is referred to earnings-per-share or EPS.

 

Earnings-per-share (EPS) = Net income / Diluted share count

 

An EPS of $2.00 means the company generates two dollars for every share outstanding.

 

There are two ways to calculate EPS: basic and diluted EPS.

 

Basic EPS represents net income divided by basic shares outstanding.

 

Diluted EPS represents net income divided by diluted shares outstanding.

 

Diluted EPS is the more commonly used metric in financial analysis because it provides a more conservative calculation than basic EPS.

 

[] Asset turnover

 

Businesses invest in assets in the hopes of getting a return. As a result, one way to measure how efficiently a business uses its assets is through asset turnover.

 

Asset turnover = Sales / Average total assets

 

Average assets simply means the balance of assets between the beginning and end of the period.

 

Asset turnover measures how efficiently a business uses its assets to generate sales.

 

For instance, an asset turnover ratio of 1.2 means that the business generates 1.2 dollars in sales per dollar invested in assets.

 

Obviously, a higher asset turnover is more desirable.

 

[] Return on assets

 

In business, we often want to get a certain return on our investments. This is why return analysis is a crucial part of financial analysis. Return analysis just refers to the percentage return we get back for every dollar of investment.

 

Let’s consider return on assets.

 

Return on assets (ROA) = Net income / Average total assets

 

By average assets, I mean the average balance over past two periods.

 

Return on assets measures the return the company generates (i.e. profit) for every dollar invested in assets.

 

A return on assets of 20% means the business generates 20 cents of profit for every dollar invested in its assets.

 

Return on assets can actually be broken down even further through simple math.

 

Return on assets can also be calculated as net margin multiplied against asset turnover.

 

Remember, net margin represents net income over sales. Profit margin tells investors how much the company brings home in profit for every dollar of sales generated.

 

Asset turnover (which we just discussed) measures how efficiently the Company uses its assets to generate sales.

 

The main reason to look at the break down of the ROA formula is to better understand how the company uses its assets to generate profit.

 

Some companies have very low asset turnover ratios, but make up for it with higher margins. An example of would be a jewelry store. Jewelry stores turnover (sell) inventory very slowly, but each sale has a very high margin.

 

Other companies might have high asset turnovers and low profit margins. An example of this would be grocery stores. Grocery stores don’t make too much profit per item sold, however, they make up for it with a ton of volume.

 

[] Return on equity

 

In college it actually took me a while to understand what “equity” is. There are a ton of complex definitions, but here’s what it boils down to.

 

Equity represents:

 

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p<>{color:#000;}. Amounts shareholders have invested into the business (i.e. if the company issues shares in exchange for cash), and

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p<>{color:#000;}. Profits that have been reinvested into the business.

 

As investors we want to know the amount of profit the company generates from the capital investors have invested into the business. In other words, we want to know the return on equity.

 

Return on equity (ROE) = Net income / Average total equity

 

ROE measures the return (i.e. profit) the Company earns from the amount shareholders have invested in the business.

 

ROE is a very famous metric because it can be broken down into smaller components. This is referred as the DuPont framework or DuPont analysis.

 

This method to measure profitability was pioneered by the DuPont Corporation in the 1920s. And it is still used in corporate finance today.

 

 

The DuPont formula breaks down the return on equity formula into return on assets and an equity multiplier. As we discussed previously, return on assets can be broken down into profit margin multiplied against asset turnover.

 

As a result, the three components of the DuPont formula are (1) profitability (I.e. profit margin), (2) asset activity, and (3) financial leverage.

 

Financial leverage just refers to the amount of debt on the company’s balance sheet. Financial leverage in this case is calculated as total assets divided by total equity.

 

Through the DuPont formula, we can see a company is able to generate higher ROE through:

 

*higher margin per dollar of sales

*faster turnover of assets

*and/or higher financial leverage.

 

Keep in mind that there are trade-offs with all three components. Increasing leverage can increase profits. However, too much debt can put the Company at risk of bankruptcy.

 

Here’s one thing to keep in mind when evaluating return on equity:

 

Many companies repurchase shares constantly. This is actually a good thing because remaining shareholders will hold a bigger slice of the pie.

 

However, for companies that do BIG share repurchase, it can make ROE seem higher than it actually is.

 

This is because for accounting purposes, stock purchases reduce equity (the denominator in the ROE equation).

 

Share buybacks will mathematically increase the ROE.

 

So keep this in mind if a business borrows money to buy back a ton of shares. This has been a common strategy in recent years with interest rates near all time lows.

 

Activity ratios

 

Activity ratios are financial analysis tools used to evaluate the ability of a company to convert assets and liabilities into cash or sales.

 

The faster a business is able to convert its assets into cash or sales, the more “efficient” it runs.

 

[] Accounts receivable turnover and DSO

 

Most business transactions are not conducted with cash, but through short-term credit terms (like ‘pay within 30 days’). As a result, accounts receivable represents a customer “IOU”.

 

That’s why it’s important to analyze accounts receivable in detail.

 

Accounts receivable turnover = Revenue / Average accounts receivable

 

This metric calculates how often the average receivable balance at the Company is collected throughout the period.

 

A receivable turnover ratio of 10, means the average receivable balance is collected 10 times throughout the period.

 

A higher receivable turnover ratio is more desirable because it means the business converts receivables (IOUs from customers) to cash faster.

 

Say we wanted to figure out how long it took the company to collect on its receivables due from customers. This is referred to as “days sales outstanding” or DSO.

 

Days sales outstanding (DSO) = # of days in period / Accounts receivable turnover ratio

 

If we were comparing annual figures, the days in the period would be 365. Similarly, if we were comparing quarterly figures, the days in the period would be 90 days.

 

A DSO of 30 days means that the average accounts receivable balance is collected in 30 days.

 

DSO is an important figure to analyze because it shows how fast a business is able to convert receivables to cash. The faster the collection period, the better.

 

Typically, we should compare accounts receivable turnover and DSO relative to prior year results. If DSO increased, we would want to figure out why.

 

For instance, did the Company extend payment terms to customers? Did they have trouble collecting from financially troubled customers?

 

Conversely, if DSO declined, we would want to figure out why. Did the company incentivize customers to pay early? Did the company do a better job of identifying troublesome customers?

 

[] Inventory turnover and DSI

 

Inventory turnover is a similar metric to receivable turnover.

 

Inventory turnover = Cost of goods sold / Average inventory

 

It calculates how often the average inventory balance is sold during the period.

 

An inventory turnover ratio of 15 means the average inventory balance is sold 15 times during the period.

 

A higher inventory turnover is more desirable because it means the business is able to convert merchandise inventory into sales (and thus cash) faster.

 

Another important metric to consider is determining how long it takes the company to sell its average inventory balance. This is referred to as ‘days sales of inventory’ or DSI.

 

Days sales of inventory (DSI) = # of days in period / Inventory turnover ratio

 

A DSI of 60 days means it takes the company 60 days on average to sell its inventory.

 

DSI is a closely followed metric because if a business has too much inventory, it may have miss-forecasted demand. As a result, it may have to reduce prices or increase sales promotions to rationalize inventory.

 

[] Accounts payable and DPO

 

The final turnover metric we’ll look at is accounts payable turnover. Accounts payable represents obligations to pay vendors for purchases made on credit.

 

Accounts payable turnover = Cost of goods sold / Average accounts payable

 

Accounts payable turnover shows how many times the average vendor payable balance is paid during the period. A ratio of 10 means the average accounts payable balance is paid 10 times throughout the period.

 

Similar to the other turnover metrics, it is often a good idea to calculate how long it takes a business to pay its average payables balance. This is referred to as ‘days payable outstanding’ or DPO.

 

Days payable outstanding (DPO) = # of days in period / Accounts payable turnover ratio

 

DPO effectively shows how long it takes a business to pay its suppliers/vendors. For instance, a DPO of 30 means that the business pays its suppliers within 30 days on average.

 

[] Cash conversion cycle

 

Once DSO, DSI, and DPO have been calculated, we have a much better understanding of how fast the company generates cash. We can take these metrics one step further by calculating the cash conversion cycle.

 

Cash conversion cycle = DSI + DSODPO.

 

The cash conversion cycle tells investors how many days it takes the company to purchase inventory, repay vendors, and collect on receivables from sales to customers.

 

Obviously, a lower cash conversion cycle is desired because it means the business will be able to convert its assets to cash faster!

 

[] Liquidity analysis

 

Liquidity refers to how easy it is to convert assets to cash. Assets such as accounts receivable are typically much easier to convert to cash than long-term assets such as office buildings.

 

The purpose of liquidity analysis is to determine if the company can meet its short-term obligations. The most common method to evaluate short-term liquidity is through the current ratio.

 

Current ratio = Current assets / Current liabilities

 

Remember, current assets are assets that will be utilized within one year and current liabilities are liabilities that will be paid (or settled) within one year.

 

If the current ratio is greater than 1, it typically signals a healthy ability to meet short-term obligations. The higher the current ratio, the more capable the Company is of paying its short-term obligations.

 

If the current ratio is less than one, it may signal that the company may need to rely on long-term credit financing or issuing equity to fund cash shortfalls…or in the worst case, run into a liquidity crunch (i.e. bankruptcy).

 

Leverage analysis

 

When I first started out investing, I didn’t pay attention to leverage as much. One of the companies I invested in nearly went under because of a massive debt load.

 

While they didn’t go bankrupt, I did lose money. That taught me a valuable lesson about leverage.

 

Now, one of the first things I check on the balance sheet is the amount of debt/leverage.

 

[]Interest coverage ratio

 

One commonly used metric to assess leverage is called the interest coverage ratio.

 

It is calculated as Net income before interest expense and income taxes divided by interest expense.

 

Interest coverage ratio = (Net income + interest expense + Income taxes ) / (Interest expense)

 

The metric measures how easily a business can pay periodic interest expense on outstanding debt with available earnings.

 

A higher interest coverage ratio means the company has a higher ability to pay interest on its debts.

 

Generally speaking, an interest coverage ratio of less than one is very concerning because it means the Company is unable to cover basic interest expense (let alone principal repayment). In such a scenario, bankruptcy is a very likely scenario.

 

[]Debt-to-equity

 

Debt-to-equity = Debt / Equity

 

This measures how much debt is used to finance assets relative to the amount shareholders have invested in the business.

 

All else equal, the higher the debt-to-equity ratio, the higher the risk of insolvency. Conversely, a lower debt-to-equity ratio implies a more financially stable business.

 

It’s a simple formula, but very effective. Never invest in a business that is over-levered with debt.

 

Keep in mind that some industries will inherently have higher leverage than others.

 

For example, casinos, real estate businesses, and certain manufacturing companies will have higher leverage. This is because they must finance the purchase of big, expensive assets over multiple decades.

 

As a result, try to focus leverage analysis of companies within the same industry.

 

[]Debt/EBITDA

 

The other popular leverage ratio used by investors is debt-to-EBITDA. In fact, this is a commonly used metric by banks and credit agencies to assess a company’s likelihood of defaulting on debt.

 

It is calculated: Debt / EBITDA.

 

EBITDA simply represents net income plus interest expense, taxes, depreciation expense, and amortization expense.

 

Investors use debt-to-EBITDA to measure how well a company can cover its debts based on earnings.

 

A higher ratio means the company has more debt per dollar of earnings. Conversely, a lower ratio generally suggests a more financially stable business.

 

Keep in mind that different industries have different benchmarks for leverage. Some industries like retail stores hardly use any debt, while it may be very common for companies in the casino industry to use a ton of leverage.

 

[] Dividend yield

 

Dividend Yield = Sum of Annual Dividends / Stock Price

 

This ratio is important because it tells investors what the stock yields (i.e. pays out as dividends) at the current stock price.

 

Generally speaking, a higher dividend yield is more desirable. However, you should always be skeptical of a very high yielding stock (i.e. 8%+).

 

Sometimes a company’s stock price has fallen significantly (due to bad results, a big customer loss, etc), however it just hasn’t cut the dividend yet.

 

Let’s say a stock currently pays an $8 dividend and its share price declined from $200 to $100 due to fears about cash flow liquidity. Now it yields 8%! Sounds like a good investment right?

 

Not so fast!

 

This is likely one of those situations where the stock price declined significantly and the dividend still has to “catch up.”

 

High dividend yields are not always sustainable!

 

To evaluate dividend sustainability, we have to use the dividend payout ratio.

 

[] Dividend payout ratio

 

Dividend Payout = Dividend-per-share / Earnings-per-share

 

This metric tells us how much of profits the company paid out to shareholders as dividends.

 

For instance, a dividend payout ratio of 40% means the business is paying 40% of profits to shareholders as dividends.

 

Typically, we want to avoid businesses with a very high dividend payout ratio (70%+). This is because when profits fall, the dividend may not be sustainable.

 

Here’s one thing to keep in mind when evaluating the dividend payout ratio:

 

Sometimes companies record charge-offs of assets or there may a large one time non-cash item that impacts earnings.

 

As a result, this may cause the dividend payout ratio to look higher than it really is. In these circumstances, it is fine to compare the dividend per share relative to cash flow per share (instead of earnings).

 

Valuation

 

Valuation is always important with buying stocks. After all, we just want to get a good deal for our money!

 

Valuation just refers to how cheap (or expensive) a stock is relative to profits, cash flow, sales, or some other financial metric.

 

We’ll discuss the most popular valuation metrics in this book.

 

[]Price-earnings ratio

 

Price-earnings ratio (P/E) is the most widely used valuation metric.

 

Price-to-earnings ratio (P/E) = Stock price / Earnings-per-share (EPS)

 

The earnings per share in the denominator is calculated as net income dividend by the diluted share count.

 

Diluted share count represents all shares outstanding plus any securities that can be converted into common shares.

 

P/E measures how much investors are paying for a business relative to its profits.

 

For example, a P/E ratio of 15x means investors are paying 15 dollars for every dollar of profit the business generates.

 

Keep in mind that more often than not, very cheap stocks (i.e. trading for a 30%+ discount relative to peers) are cheap for a reason: they're just bad businesses. 

 

While the P/E ratio is a great valuation tool to use, there are a few things to consider.

 

First, the P/E ratio doesn’t consider the capital structure of the business. In other words, it doesn’t account for the level of debt a business has.

 

Would you want to invest in a stock that trades at a P/E ratio of 5x, but has debt worth 20x earnings? Probably not!

 

Second, sometimes it may be useful to compare the current stock price relative to future profits.

 

This is called the forward P/E ratio because we’re comparing the current stock price to future (or “forward”) earnings.

 

Typically, the stock price is compared to earnings 12 months into the future. So, a stock with a forward P/E ratio of 20x means investors are paying 20 bucks for every dollar of future expected profit.

 

[] Price/cash flow

 

Some people don’t like net income in valuation because it’s based on “accounting” numbers. As a result, they like to rely on cash flow instead.

 

Price-to-cash flow measures how much investors are paying for a business relative to the cash it generates.

 

Price-to-cash flow = Market capitalization / Cash flow from operations

 

For example, a price-to-cash flow ratio of 16x means investors are paying 16 bucks for every dollar of cash flow generated.

 

Another reason why some people like to use price-to-cash flow is because it excludes the earnings impact of non-cash expenses such as depreciation and amortization.

 

While price-to-cash flow has its uses, I would always use it in conjunction with the P/E ratio when valuing stocks.

 

[] Price-to-sales

 

Price to sales (or P/S) is a very popular valuation metric for fast growing companies.

 

Price-to-sales = Market capitalization / Twelve-month sales

 

The reason why some stocks are valued based on sales is because they don’t generate any profits! As a result, the ONLY way investors can evaluate them is by sales!

 

Price-to-sales (aka P/S) is calculated as the market capitalization of the business divided by sales over the past twelve months.

 

Price-to-sales measures how much investors are willing to pay for the business for every dollar of sales generated. A price to sales ratio of 2x means that investors are willing to pay $2 for every dollar of sales the business generates.

 

[] Price-to-book

 

Price-to-book (P/B) is a very popular metric among value investors (especially Warren Buffett supporters).

 

Let’s first define a few terms. Book value is a very important tool in financial analysis.

 

It represents the net assets of a business (total assets minus total liabilities). In essence, it is the theoretical value of a business if it were liquidated.

 

Book value per share represents the book value of the company divided by the diluted share count.

 

One metric investors utilize in certain industries is the price-to-book (P/B) ratio.

 

Price-to-book = Share price / Book value-per-share

 

P/B measures how much investors are paying for the net assets of a business. By net assets, I mean total assets minus total liabilities—this is basically a stock’s “tangible” net worth.

 

For instance, a price-to-book ratio of 1.5x means investors are paying 1.5 times the net assets of the company.

 

Price-to-book is a useful metric for businesses with primarily tangible assets such as a manufacturing business or a bank or even an insurance company.

 

It is less useful to evaluate companies that rely heavily on intangible assets (like patents, brands, or trademarks) such as technology companies or pharmaceuticals.

 

[] EV/EBITDA multiple

 

The final valuation metric we’ll enterprise value-to-EBITDA.

 

But first, we need to define a few terms.

 

Recall that the market capitalization is the dollar market value of a company’s outstanding shares. Some people like to use enterprise value instead because it takes into account the level of debt the business has.

 

Enterprise value (EV) = Market capitalization + Preferred shares + Debt + Minority interests – Cash.

 

As I mentioned earlier,EBITDA represents earnings before interest, taxes, depreciation, and amortization.

 

EV/EBITDA measures the multiple a potential acquirer might pay for a company.

 

In the event of a buyout, the acquirer would generally (1) pay for the fair value of the Company, (2) take on the company’s debt, and (3) receive any cash on the acquiree’s balance sheet.

 

An EV/EBITDA multiple of 7 means that a potential acquirer would be essentially paying $7 for every dollar of profit the business generates.

 

A higher EV/EBITDA ratio means that a potential acquirer would have to pay more to acquire the business for every dollar of profit earned.

 

[] Final Thoughts

 

Getting a grasp of basic financial ratio analysis is very important to make money investing. Hopefully you will be able to apply these concepts and start earning returns!

 

Thank you for reading.

 

If you enjoyed this book please consider leaving a review! I take all feedback seriously and it helps me to continue producing great content for everyone.

 

 

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Financial Analysis: Analyze Financial Ratios For Any Stock

To make money as an investor you need to be able to evaluate financial ratios and perform financial statement analysis. Learn 20+ financial ratios the best investors use to pick winning stocks. You will learn financial ratios for a variety of uses including: *Evaluating profitability *Determining liquidity *Assessing leverage *Calculating returns *Measuring activity and efficiency *Stock valuation Each chapter includes a description of the type of ratio, a discussion of the formula, and additional insights and commentary.

  • Author: Andrew P.C.
  • Published: 2017-08-11 06:20:16
  • Words: 6600
Financial Analysis: Analyze Financial Ratios For Any Stock Financial Analysis: Analyze Financial Ratios For Any Stock