Welcome to the 15th edition of Wisdom Wednesdays. I’ve poured much of my knowledge into this post and series. I hope you will find this useful. Enjoy.
Financial ratios are so important to investing. You may read an article that a company has $2 billion in profit, but that means nothing to the investor. You need to know how big the company is relative to the $2 billion number, then you can use a ratio to compare companies across the board.
For example, $2 billion in earnings might be a really bad year for one company but a great year for a much smaller one. The only way to know if all the numbers you are researching are good is by ratios.
Ratios: The Good
Ratios level the playing field and allow company to company comparisons. The important factor in all security analysis is the presence of a ratio in every category considered. Some of the most important ratios you need to understand and I teach you how to find are below.
I broke it down into easy categories to show you how and why each part is important, and how each can be calculated through ratios.
Earnings are the name of the game. When investing you need to know that you are getting enough earnings for your buck, which will turn into cash for the shareholders (you). Learn this with the P/E ratio.
Intrinsic Value of the Company
The intrinsic value is referring to the company’s assets and liabilities, and this is how business owners value a business. If you can get even $1 of assets for each $1 you invest, the downside of this investment becomes minimal. Learn how much you are paying for these assets with the P/B ratio.
If a company isn’t making revenue, then they sure aren’t going to be making profits. Earning are more volatile than revenue, and so this category is very useful in volatile time periods. Use the P/S ratio in this case.
Cash, and Utilization of Excess Cash
You want part of the company’s profits, and companies with more cash are able to pay you more. You want companies to pay you cash, but not to pay too much that it puts the company in jeopardy. To figure out these things, you’ll want to familiarize yourself with the P/C ratio, payout ratio, and dividend yield.
This category should be obvious to why it’s so important, yet it’s often overlooked. So many companies have gone under because of the burden of too much debt, and you want companies with as little debt as possible. The Debt to Equity ratio is the great equalizer, as a company can look like it’s in great shape with all the other ratios but lack in this one, ending badly for investors.
Ratios: The Bad; Common Pitfalls
Great, so I learned about one ratio like the P/E ratio. I can just use this one when picking stocks and I’ll be fine right? No you’re wrong. While knowing about one ratio will help you out tremendously, there are some other things you must consider.
Every ratio, P/E ratio especially, varies depending on the sector. Automotive companies like Ford (F) tend to have much lower P/E ratios than technology companies like Microsoft (MSFT). A P/E of 15 would be great for a technology company but not so great for an automotive company.
This is why I always stress looking at multiple categories. And I’ve narrowed it down so all your bases are covered.
The amazing thing is that the differences in sectors will cancel each other out. A company who has a low P/E ratio because they manufacture cars will consequently have a much higher debt to equity ratio than a technology company.
It makes sense if you look at it this way. An automotive company needs much more capital to build factories and hire workers than a technology company does. The technology company doesn’t have as many expenses, and therefore will have much lower liabilities.
Lower liabilities correlates with a lower debt to equity ratio, which is very desirable. But these technology companies tend to earn less profits than a business with more concrete assets, and so their P/E ratios are very high.
As you can see, a technology company’s biggest advantage, needing less money to operate, is also its biggest disadvantage. The company will have less debt but also less ability to generate earnings as easily.
There are many of these variations when looking at ratios. But as you can see, you don’t have to worry about these subtleties as long as you are looking at a broad enough range of categories.
I teach about the important categories you need to consider, nothing more and nothing less. It may seem overwhelming at first, but if you can master my 7 steps you will know everything you need to fully analyze companies and stocks.
Ratios: The Ugly
By using ratios and multiple categories, you will be able to compare any stock to another. The power of this knowledge is limitless. [Tweet This] The only ugly side of ratios are your results if you don’t use them.
Analyze a stock right now. It’s not as hard as you thought. If you need help, get my free ebook 7 Steps to Understanding the Stock Market with your email subscription.
**All Rights Reserved. Investing for Beginners 2013**
**Financial Ratios: The Good, The Bad, and the Ugly**
**Link for the photo above found here: Photo Attribution**