This week, we continue our journey of navigating financial metrics. Some believe there is a secret sauce to investing, or better yet, they have it. The reality is that investing is a calculated risk. Equipped with the proper knowledge, you can transform from a bewildered wanderer to a confident navigator of the financial markets.
You will be equipped with these financial metrics in your toolbelt on this journey. This set of metrics focuses on using a quantitative approach to the company’s financial health, performance, and future growth opportunities. Our team of financial advisors (or financial teachers) Whitaker-Myers Wealth Managers are ready to join your quest and provide additional guidance and tools on your journey.
The Metrics Toolbelt
Four broad ratios must be reviewed when analyzing a company's or investment's health and outlook. These include profitability ratios, liquidity ratios, solvency ratios, and valuation ratios.
Profitability ratios look at whether a company is capable of generating a profit and revenue growth. This is one of the most important sets of ratios to look at when analyzing a company. If the organization is not growing (revenue) or profits are down significantly, the stock will likely reflect. Key metrics that focus on profitability are gross profit margin, net profit margin, and return on equity (ROE).
Gross Profit Margin
Measured by calculated net sales minus the cost of goods sold. This is reported as a percentage of net sales. “Gross profit margin shows the amount of profit made before deducting selling, general, and administrative costs, which is the net profit margin” (Investopedia.com).
Net Profit Margin
As mentioned in the quote above, the net profit margin considers all expenses. A higher net margin signifies greater profitability.
Return on Equity (ROE)
This is a measure of how efficient a company is in generating profits. Calculated by dividing a company’s net income by shareholder’s equity. When determining if the ROE is good/bad, evaluate other stocks in the same sector. If the calculated average amongst the selected group is lower than the ROE of the stock you’re looking at, you’re in good shape!
“Liquidity is the ability to convert assets into cash quickly and cheaply” (Investopedia.com).
Liquidity ratios measure a company’s ability to meet its short-term debt obligations without raising additional capital. These ratios are specifically looking at short-term obligations. Here, we’ll discuss two liquidity ratios: the current ratio and the quick ratio.
Quick note: anytime you hear ‘current’ in a financial discussion (current ratio, current asset, current liability…), think of the short term, less than one year.
The current ratio measures current assets (cash, accounts receivable, and inventory) divided by current liabilities (any short-term debt obligations). A current ratio of 1 or greater is a good sign. This means the company has enough assets to cover its short-term obligations over the next year. On the other hand, a value of less than 1 would suggest that the company is in a riskier position and may not have all the assets to cover its liabilities over the next year.
The quick ratio has a much more complicated formula. However, the simplest way of understanding the quick ratio is that it excludes inventory from current assets (unlike the current ratio). This ratio measures immediate liquidity by focusing only on available cash and accounts receivables. A healthy quick ratio is typically above 0.5.
Unlike current ratios, solvency ratios measure a company’s long-term capability to handle its debt. Organizations with higher solvency ratios tend to be the stronger investments for investors. Prospective lenders also widely use solvency ratios when determining a company’s creditworthiness. Within the category of solvency ratios, we’ll focus on 2 in this article: Debt-to-Equity and Interest coverage.
This compares a company's debt to its shareholder equity. A lower ratio indicates a healthier balance sheet with less reliance on debt. It is measured by dividing total outstanding debt by equity.
Interest Coverage Ratio
This ratio calculates the company’s ability to meet debt interest obligations in the specified period. This ratio is calculated by dividing EBIT (earnings before interest and tax) by Interest expenses. A ratio greater than 1 signifies sufficient cash flow to cover interest expense.
Valuation ratios are another category of metrics to keep in your tool belt. These key metrics are widely used to estimate the company’s intrinsic value and future growth opportunities. Commonly, they are also used to evaluate current stock prices. Two of the most common valuation ratios are the Price to Earnings (P/E) and Price-to-book (P/B) ratios.
Price-to-Earnings Ratio (P/E Ratio)
This metric is calculated by measuring the price of a stock divided by the company earnings. A lower P/E ratio generally indicates undervaluation and opportunity to grow.
Price-to-Book Ratio (P/B Ratio)
This metric is calculated by measuring the price of a company’s stock divided by the book value per share (BVPS). The book value per share measures all company assets minus liabilities. A lower P/B ratio might imply a bargain buy; values <1 are good to track.
Toolbelt Filled, Now What?
Remember, when you look at financial metrics, it’s never about one metric or one data point. A complete analysis must be conducted to understand if the investment is right for you.
I’ve mentioned this in previous posts, but when discussing any metric, remember that a benchmark also requires a like-to-like measurement. Measuring one valuation metric of a company in the Tech sector vs. a company's valuation in the manufacturing sector is not a good comparison measurement. At the end of the day, financial metrics only tell you a picture at that given moment.