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Chapter 3. The Basics of Fundamental Ana... > Key Financial Figures and Ratios

Key Financial Figures and Ratios

If you really like to invest based on fundamental analysis, I would recommend you try out software applications, such as Vector Vest or ValueLine, which provide not only all the fundamental analysis for you, but also include automated searches and filters for the Fundamental Analysis of stocks. Let’s have a look at the most important figures you’ll see when analyzing a company and what the best search criteria are.

FigureCalculationComments and Significance
BetaBeta measures the relationship of a stock’s returns relative to the market in general (S&P 500 in the USA). With par set at one, anything at a Beta of 1 indicates that the stock will move in the same direction as the market and at the same rate. If a stock has a Beta of 1.2, it will move in the same direction as the market but where the market moves by, say 10%, the stock will move by 12% (10% plus another 2%) in the same direction.If a stock has a negative Beta, this means that it moves in the opposite direction to the market. −1 indicates that the stock will move at the same speed as the market but in the opposite direction.If you want to trade the market as it goes up and down, then Beta is a useful figure for you.

If the market is rising, pick top quality stocks with a high positive Beta.

If the market is falling, you can sell short the worst stocks with a high Beta.

Beta is a useful addition to any search criteria once you are comfortable with the prevailing direction of the market.
Current Ratio

The Current Ratio is a measure of the company’s liquidity, and its ability to pay its immediate debts. Again, you want this figure to be high. A figure below one would indicate that the company doesn’t have the liquid funds to pay its obligations. Look for some safety margin in this area.
Dividend Cover

As with Interest Cover, if you’re interested in dividends, then look for companies with sufficient dividend cover, to ensure that the dividends will continue. There is often a trade-off between dividend yield and dividend cover. Obviously where there is high dividend cover (and therefore a safer dividend), the dividend yield may be lower because the PE ratio (hence share price) may be higher, thus lowering the dividend yield.
Dividend Yield

Many US stocks pay low or no dividends. In the UK, many investors hold stocks purely for the dividends. Look for consistency in the company’s dividend policy and for dividends to rise steadily over time. Companies with wildly fluctuating (up and down) dividends year after year are those that suggest poor management.
Earnings per Share (EPS)

Estimated EPS GrowthThis is the average estimate of EPS growth for the indicated period, as derived from all polled estimates from Wall Street or City analysts.The thing to watch out for here is if actual results exceed beyond or lag behind analysts’ expectations. Look for companies that consistently exceed analysts’ expectations—Microsoft did this consistently up until 2000.
Financial Gearing or Leverage(Interest Bearing Loans + Preference Shares/Ordinary Shareholders’ Funds)

Interest bearing loans will include all long and short -term debt obligations including bonds, notes payable, mortgages, and lease obligations.

“Ordinary shareholders” funds’ effectively shows the funds provided to the company by its common stockholders. The Shareholders’ Funds figure comes from the balance sheet. This figure will incorporate common equity, long-term debt, deferred taxes, and minority interests.

The ratio indicates how much financial leverage or gearing the company has.
This is a juggling act for the company. Generally you don’t want to see it gearing too high, and it really does depend on the sector and type of business the company operates within. Sectors differ as to commonly acceptable gearing ratios. Beware of companies whose gearing is significantly higher than their competitors. High gearing generally means higher risk because if the company defaults on a loan, it could spell disaster if the creditor calls it in.
Forward P/E

This is based on a prediction of earnings.
Interest Cover

Highlights the company’s ability to pay its interest obligations. The higher the figure, the safer the company is. I would look for at least three times interest cover.
Net Assets per Share (Book Value per Share)

Shows the Book Value per share. If the share price is lower than the book value per share, either the stock is a complete dud, or it is undervalued.
Payout Ratio

The payout ratio is a useful way of looking at how much a company is reinvesting in itself. High-growth companies tend not to pay dividends because they are constantly reinvesting for future growth. Mature companies, such as Phillip Morris, will pay a dividend, but you need to make sure that they are also reinvesting adequately. Property companies and REITs (Real Estate Investment Trusts in the USA) tend to pay higher dividends than most; REITs are compelled to pay out a high percentage of their net revenues as dividends or face punitive tax measures.
PEG Ratio

A popular ratio made famous by the Beardstown Ladies Investment Club. The PEG Ratio is often used to spot undervalued or overvalued stocks. If a company has high growth prospects but a PEG Ratio of less than one, then this company could be thought of as being undervalued. A PEG Ratio of less than one means that the forward multiplier (PE ratio) is less than the projected growth of the company. Many investors look for PEGs of less than one in the search for undervalued or good value stocks.
Price/Book Value

If a stock price is less than the Book Value per share, the stock is described as being at a “discount to Net Asset Value.” Either this can mean that the company is undervalued (because the company could be liquidated for more than its market capitalization), or it can mean that the company is in really bad shape, hence its poor rating and stock price.
Price/Cash Flow

All figures incorporating elements of cash flow are useful for investors. Look to see that the company is generating cash consistently over time. If there is a sudden change, check the news to see if the company has a major investment drive going on or some changes in its investment strategy that may have affected its cash flow.

Useful for cross-comparing companies that have made earnings with those that haven’t.
Price Earnings (P/E) Ratio

Signifying the market’s rating of the company, the PE ratio is a multiplier of the company’s earnings to evaluate its value in the marketplace. As with all these figures and ratios, you shouldn’t look at the PE ratio in isolation. Instead, compare it with past price data on the stock and with the stock’s competitors within its industry sector. A low PE ratio signifies a low rating by the market; this can either mean the stock is fundamentally weak or that it is undervalued. A high PE ratio can either mean the company is fundamentally strong or that the company is overvalued. To assess what is the reality, analysts look at other facts, figures, and ratios as well.
 The same end figure can be reached by the following calculation:

Quick Ratio (Liquid Ratio)

A more examining test of a company’s liquidity, the Quick Ratio facilitates easier comparison between companies because they might take on different valuation approaches for inventories.
Return on Assets (ROA)

The percentage rate of return on all the company’s assets.
(Return on Capital Employed (ROCE)) Unlike ROE (return on equity), ROA does not net off the company’s liabilities and is a measure of how effectively a company is investing its money.
Return on Equity (ROE)

ROE is a measure of how effectively a company is using its investors’ money.
Five-year EPS Growth RateThe five-year annualized growth rate of Earnings per Share.Good for measuring EPS growth over a period of time. This figure takes into account management’s track record of adding to shareholder value and, as such, is a useful pointer to the future. Use in conjunction with five-year sales growth to ensure that the growth in EPS is attributable to increasing revenues, and not simply management using corporate and accounting policies and financing techniques to bolster EPS. Such techniques may be totally legitimate and useful, but a company’s long-term performance will be partially based on its ability to produce quality products and services of which it can continue to sell more.
  An example of a method used to enhance shareholder value includes share buybacks where the company buys back some of the shares, which reduces the float and therefore increases EPS because there are fewer shares now to divide into the Earnings figure. Similarly, a company might be able to enhance EPS by cutting down its expenses and making mass redundancies. Efficiency is to be applauded, but you must ask the question: how is it improving sales revenue in the longer term?
Five-year Sales GrowthThe five-year annualized growth rate of Sales or Revenues.This figure demonstrates that the company has a compelling product or set of products and services that are being bought by its customers in increasing amounts. Sales growth can occur as a result of increasing sales units and/or increased unit prices. Think about the markets to which the company already sells its products and services and whether it can expand into new markets, both geographically and in terms of business sector.



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