Picking Winning Stocks: 8 Key Ratios

Picking a stock to invest in and profit from is not easy. If it was, everyone would be making tons of money from the stock market. People and companies spend years (and millions) developing and fine tuning an approach to selecting stocks using complex mathematics and powerful computers.

Does that mean that ordinary investors like us are out luck? In my opinion, the answer is NO.

I believe that by studying the foundations of finance and investing, you can still pick stocks that earn you a healthy return. In fact, I would highly encourage you to read some of the classic books in this field like The Intelligent Investor and Beating the Street. These books are a great way to get one (big) step ahead of other causal investors.

In the remainder of this post I will share with the 8 key ratios or metrics that I look at when evaluating whether to invest in a stock.

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1) Operating Margin

Operating margin is a profitability ratio that measures the percentage of profit that a company makes from each dollar of sales revenue. It is calculated as:

Operating Profit / Net Sales x 100

This ratio gives us an indication of whether a business’ pricing strategy allows it to earn a healthy profit margin as well as its ability to control its operating costs effectively. In general, the higher the operating margin the better the performance of a company.

2) Return on Assets

Return on Assets is also a profitability ratio that measures the percentage of profit that a company makes from each dollar of assets it holds. It is calculated as:

Net Income / Total Assets x 100

This ratio gives us an indication of how effectively a business uses it assets to generate profits. In general, the higher the return on assets the better the performance of a company.

However, it is important to note that an unusually high return on assets relative to a company’s competitors that cannot be clearly explained may indicate an under investment in assets. This can signal a weaker outlook for the company.

3) Debt to Equity

Debt to Equity gives an indication of the financial health of a business. It measures how much debt a company owes to its creditors for every dollar of equity that its shareholders hold. The ratio is calculated as:

Total Debt / Total Equity

In general, investors and creditors tend to favour a lower debt to equity ratio because it indicates a better ability for a company to cover its debt obligations using its other assets. Moreover, a lower ratio also signals more headroom to quickly gain access to credit to pursue growth opportunities. Conversely, a persistently low ratio can mean that a business has difficulty in securing loans or does not have a healthy funnel of growth opportunities.

4) Payout

Payout ratio measures how much money a company pays its shareholders for every dollar of profit it earns.it is calculated as:

Total Dividends / Net Income

A low payout ratio means a business is not paying out much of its profits to shareholders as dividends. This may be unattractive to an investor looking for a steady stream of income from his or her stock holdings. A low ratio may also indicate a company reinvesting its profits back into fund growth. Many companies going through an aggressive growth phase have a low or zero payout ratio.

On the other hand, a high payout ratio may indicate little room for future dividend growth or lack of investment in growth or a higher reliance on debt to finance investment needs. A payout ratio greater than 1 means that the business is paying shareholders more than it earns in profits which is unsustainable.

5) Dividend Yield

Dividend yield ratio measures how much money you can expect to earn per year for every dollar you invest in buying shares of a company. It is calculated as:

Annual dividend / Current Stock Price

While a high dividend yield can mean a good investment because the share price is low compared to the payout to shareholders, it can also indicate a low stock price due to difficulties a company is encountering or an unsuitable dividend. In general, investors tend to favour a high dividend that is stable or in an increasing trend over several years.

6) Free Cash Flow to Sales

Free Cash Flow to sales ratio measures how much free cash a company generates for each dollar of sales it makes. It is calculated as: 

Free Cash Flow / Net Sales

Free cash flow is the cash flow that a company has left over to pay off its debt and shareholders after paying for its capital expenses, which are used to maintain or grow their assets. A low or decreasing free cash flow to sales ratio indicates ineffectiveness to convert sales into cash. In general, the higher the ratio the better performance of the company.

7) Price to Cash Flow

Price to cash flow ratio measures a company’s stock price relative to the cash flow it generates. It is calculated as:

Current Stock Price / Cash flow

While the ratio itself does not give useful information on its own, the ratio is useful to compare between companies within the same industry or across several years for the same company. In general, the lower the ratio the better value a stock is considered.

8) Price to Earnings

Price to earnings ratio measures a company’s stock price relative to the earnings it generates. It is calculated as:

Current Stock Price / Earnings per Share

While the ratio itself does not give useful information on its own, the ratio is useful to compare between companies within the same industry or across several years for the same company. In general, the lower the ratio the better value a stock is considered.

What's next?

While there are many other financial ratios that can be analysed, these 8 ratios are the key ones I consider in many of my stock evaluations.

In the next part of this series I will show you how you can use these ratios to identify and shortlist stocks that you may want to consider investing in.

  • February 6, 2018
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