Investment Research Guide

In this post I will include descriptions of investing ratios and what I look for when I choose a stock to invest in.

Quality
Growth
EPS% This is the average growth of their Earnings Per Share. I use the averages for the last 3,5, and 10 years.
To calculate the Earnings per Share, or EPS, you divide the company’s net income by the number of shares outstanding during the same period.

REVENUE% This is the same thing as ESP% except that we are using the growth of the Revenue instead of Earnings.  Revenue is the total amount of money brought for the company. I also use the averages for the last 3,5, and 10 years.

Profitability
Profit Margin, or PM, also called net margin, or net profit margin, is calculated as net profits divided by the revenue, or sales. This measures how much of their revenue they get to keep.  A high profit margin means that the company is efficient and is able to control their costs.  I look for profit margins that are higher than their competitors in the same industry. I also look to see if the company is increasing their profit margin throughout the years.  If they are it means that the company is improving and lowering the cost of their operations which could mean that they are building a competitive advantage that their competitors could not match.

Operating Margin, or OM, is the proportion of revenues remaining after paying the costs of operating the business, such as labor costs (wages), raw materials, overhead, depreciation and amortization, selling, general, and administrative expenses, advertising, etc. It is similar to the profit margin except it does not include all costs, so it will be higher than the profit margin. Operating margin can be calculated by dividing Operating Profit by Net Sales.

Return on Assets, or RoA, measures how profitable a company is relative to the total assets of the company.  RoA tells how efficient management is at using its assets to generate earnings. If it is high it is high then the management is doing a good job at allocating its resources. The assets of a company include both debt and equity, so if a company has no debt their Return on Assets and Return on Equity would be the same.

Return on Equity, or RoE, is similar to RoA except for instead of comparing assets we are comparing the earnings to the Shareholder Equity, which is the Total Assets minus the Total Liabilities. Shareholder Equity is also called the Book Value. RoE shows how efficient management is at turning the shareholder equity into earnings. Return on equity is calculated by taking a year’s worth of earnings and dividing them by the average shareholder equity for that year. I look for companies that have a RoE of at least 10% and that of higher than the competition.

Management
Insider Ownership is how much of the stock is owned by the management of the company. I look for stocks with a high percent of insider ownership, under the theory that when management are shareholders, they will act in its own self interest, and create shareholder value in the long-term.

Financial Health
Current Ratio measures how liquid the company is and shows if they have the resources to pay of their liabilities over the next 12 months.

Current Ratio = Current Assets/Current Liabilities

Current Assets are a category of Assets on the balance sheet that include cash and assets that are expected to be turned into cash within 1 year.

Current Liabilities are a category of liabilities on the balance sheet that include financial obligations that need to be payed for within 1 year.

I look for companies that have a current ratio of at least 1, preferably 2.

Debt/Equity, or D/E, Debt-to-Equity, shows how much debt the company has compared to its equity.  A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing. I look for companies that don’t have too much debt that is less than 1.  If they do have a lot of debt I look to see how efficient the company is at turning that debt into earnings with ratios such as the Return on Assets.

Valuation

Price/Earnings, or P/E, is the price of the stock divided by its EPS of the last twelve months. This is probably the most popular metric to valuing a stock. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn’t tell us the whole story by itself. It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E. I look for companies of with a P/E of less than 15 and below the industry averages.

Price/Book , or P/B, A low P/B could mean that the company is undervalued. This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately. I look for a P/B of less than 1.5 and below industry averages.

Price/Sales, or P/S, is calculated by dividing a stock’s current price by its revenue per share for the trailing 12 months. This shows how much you are paying for one year’s worth of revenue.

Price/Cash Flow, or P/CF, is the same as P/E and P/S except we are using the Cash Flow. Cash Flow is the movement of  cash into or out of the company.  I use the 3-year average for cash flow.

Dividend Yield shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. When looking at the dividend I also look at the dividend history to see if the company is increasing its dividend and at the cash the company has to see if they can support the dividend.

Earnings Yield is the inverse of the P/E ratio and is calculated as Earnings/Price. I compare the companies EY to the Earnings Yield of the interest rates.  The stock’s Earnings Yield should be much higher.

Forward P/E The Forward P/E of a company is often used to compare current earnings to estimated future earnings. If earnings are expected to grow in the future, the Forward P/E will be lower than the current P/E.

There are many other Ratios to use when researching a stock to buy, but these are the main ones that I use.  You should always do your homework when buying a stock and never buy a stock based on a hot tip you got from a friend without doing your own research on it first.  Many people like to look at charts when deciding to buy stocks, but when I look at the fundamentals when I am buying partial ownership of a company.

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