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Friday, October 4, 2019

11 Basic Financial Metrics to Value a Stock

Value investors often try to find a stock in the market that is trading in a undervalue territory. Investors usually use financial metrics to evaluate a stock whether the market overreacts to good or bad news. We can see a stock price movement that doesn’t correspond with the stock company financial fundamental. There are many successful and well known value investors out there such as Warren E. Buffett, Peter Lynch, and many others that use this strategy to analyze a stock. Looking at financial metrics gives the ability for a value investor to see whether the stock is overpriced or oversold. Also, they can use these metrics to see whether the stock is trading at a fair value or not. It is fine to buy great companies that have long term business potential at a fair price as mentioned by Warren E. Buffett himself. He also mentioned that it’s better to purchase a great company at fair price rather than a low quality company at an undervalue price. It’s great when you have this financial knowledge to evaluate whether a company is a potential buy or something that you want to avoid investing. Having the knowledge of utilizing financial metrics when investing give investors a more understanding of what’s going on with the company. People that have been following my blog know that I am a dividend growth investor who adopts value investing techniques. I’ve been using this technique since I initiated this blog to find great dividend growth stocks. It has a long term potential of increasing the companies’ dividend payout as well as capital appreciation to the stock price. I’m here now to share my experience on 11 basic financial metrics I use to find great dividend paying stocks.

1. Price-to-Earnings Ratio (P/E Ratio)
This is the basic ratio that most value investors see to value a stock. It is a simple metric that calculate the Market Capitalization of a company to its Earning (Total Net Profit). It also can calculate the Company’s Price per Share to Earnings per Share. This ratio tells you how cheap or expensive the stock is currently trading at, or how much people are willing to pay for the stock. Let’s say a company called Tom’s Taco that has Stock Price of $10 per share, and has Earnings per Share of $2. This gives the Tom’s Taco Price-to-Earnings ratio of 5. The P/E ratio shows the expectation of the market is willing to pay for the stock. By using the P/E ratio, it gives the ability for investors to know how profitable the stock is.

Let’s assume that Tom’s Taco doesn’t grow its earning and maintain the current earnings futures ahead. The P/E can show how long it takes for the stock to cover back for the price per share you pay. So if Tom’s Taco has a P/E ratio of 5 means that it will take approximately 5 years of the same earnings to pay back the amount paid for each share. I personally prefer to find companies that has Price-to-Earnings ratio of below 15 as Warren Buffett does.

In addition, this basic ratio gives the ability for people to compare a company to its competitor that are in the same industry. For example, a stock called The Gap Inc. (Ticker: GPS) is an American worldwide clothing and accessories retailer. Using the Price-to-Earnings ratio, you are able to compare its price to a competitor that is relevant to its business. For example we choose The Gap Inc. (Ticker: GPS) and American Eagle Outfitters Inc. (Ticker: AEO) for comparison. They are apparently American worldwide clothing line retailers that are in the same business sector. Comparing these two companies Price-to-Earnings ratio gives investors the ability to know which stocks are selling at discount. Let’s say The Gap Inc. has a P/E ratio of 10 while American Eagle Outfitters Inc. has a P/E ratio of 15. This shows that The Gap Inc. is trading at a cheaper valuation compared to American Eagle Outfitters since it has a lower P/E number. However, we cannot use P/E ratio to make a conclusion that The Gap Inc. is a better investment than American Eagle Outfitters just because it has a lower P/E ratio. Investors need to see other factors that may cause The Gap Inc. to trade at a lower P/E ratio.

A company that has a high P/E ratio can indicate that it’s a growth stock. It means that the market expect the stock to generate higher earnings in the future. However, the market expectation of the stock to generate higher earnings in the future can also be misled due to the company not being able to generate the expected profit. This could be down fall for the stock since the company will then be considered overvalued. In addition, a low P/E ratio company could mean that the company is trading at a discount. It means that the company is undervalued because its price is trading relatively lower than its fundamental. This mispricing could be an opportunity for a value investor such as myself to purchase the stock at a bargain.

However, this ratio does not indicate whether your investment will do great in the future just by picking a stock for its low P/E ratio. I picked a stock for its low P/E ratio thinking it was a good investment and had landed myself in value trap. The company I had landed to misfortune of losing $40,000 is called GameStop Corp. (Ticker: GME). The stock had a low P/E ratio and I was attracted to invest in the company. However, the stock was not able to earn the same income it generated before, and had drastic drop to its earning to have a net loss. This led me to sell the stock at a realized lost since I don’t have confidence in the company’s fundamental and the future prospect. This taught me a lesson that past earnings of a company doesn’t guarantee that it will do the same in the future.

2. Price-to-Sales Ratio (P/S Ratio)
Price-to-Sales ratio is used to look at company’s price to its revenue per share. This also can be calculated as the company’s market capitalization to its annual revenue. Some people use this metric to evaluate a growth company that doesn’t generate net profit. New Hot industries are often valued by Price-to-Sales ratio instead of Price-to-Earnings.

However, a value investor can utilize this metric to find companies that have potential of turning around. For example, if a company lost money in the past years, but has Price-to-Sales ratio of 0.5 while its competitors have a Price-to-Sales ratio of 3.0 or higher. This indication shows that the company could turn itself around and start being profitable. In some cases such as during the stock recession, some industries might not be profitable at that time, but that doesn’t justify that the company is bad in the future. In this case, you can use Price-to-Sales ratio to value the company’s value to its peer.

Another common use of the Price-to-Sales ratio is applying it with the Price-to-Earnings ratio to compare companies’ valuation. If a company has a low Price-to-Earnings ratio but a high Price-to-Sales ratio, it might indicate that there are some recent quarters’ earnings of a one-time gain (sales) which increase its earning per share. In this case, the low P/E ratio is not sustainable since the earnings might not occur again in the future.

3. Enterprise Value/Earnings before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA)
Enterprise value is a ratio used to determine the economic value of the company. Similar but different to Market Capitalization, Enterprise value calculates a more accurate value of the company. This is because it takes into consideration of the company’s debt obligation. When you purchase a company as a whole, you initially are purchasing the debt that shows in the balance sheet of the company as well.

To calculate the Enterprise Value of a company, you should add the market capitalization to the company’s outstanding preferred stock and all debt obligations, and then subtract cash and cash equivalents. Because I am a value investor, I see each share of stock as a small piece of the company and purchase them as if I’m buying the whole company. For this reason, I tend to check the company’s enterprise value, since it gives me a broader picture of the company as a whole. It gives me an understanding of debt obligations that the company has in the balance sheet.

A company that has a low EV/EBITDA multiple can be considered as a good takeover candidate. I tend to look for companies that has EV/EBITDA ratio of 8 or below. Just like P/E ratio, you should not base on low metric of EV/EBITDA data alone to make a conclusion whether the company is value stock. You should be aware that past performance doesn’t mean a stock would perform the same in the future. But having the knowledge of this metric gives you the ability to know whether a stock is a buying candidate.

4. Price-to-Earnings-Growth Ratio (PEG Ratio)
This ratio is one of my favorite to see whether the company has a potential of growing itself in the future. Since a Price-to-Earnings ratio doesn’t tell the whole picture of the company, PEG ratio gives value investor to see the earnings growth potential of the company. The PEG ratio is calculated as Price-to-Earnings ratio divided by the company’s expected profit growth rate.

A company that has PEG ratio below 1 shows that the company is undervalue, while a company that has PEG ratio of above 1 is considered expensive. However, PEG ratio is just one ratio to determine a company’s metric performance, and different industries have different average PEG ratios.

Let me show you some example. Let’s say you are analyzing these two companies that happened to be in the same industry. The first stock called Company A trades at Price-to-Earnings ratio of 15, while the second is called Company B is trading at P/E of 25. Just by looking at P/E ratio gives the indication Company A stock has more attractive valuation. However, let’s say that the Company A has projected growth rate of only 12% while Company B has a projected growth rate of 30%. Using this information, let’s do the math to calculate the both companies’ PEG ratio.

PEG Ratio (Company A) = Price-to-Earnings/Growth Rate
PEG Ratio (Company A) = 15/12%
PEG Ratio (Company A) = 1.25

PEG Ratio (Company B) = Price-to-Earnings/Growth Rate
PEG Ratio (Company B) = 25/30%
PEG Ratio (Company B) = 0.83

After comparing the PEG Ratio of both companies, we can come to conclusion that even though Company A’s P/E ratio is lower than Company B’s P/E ratio. However, if we take projected growth rate into account, Company B has a lower PEG ratio of 0.83.

When using PEG ratio to analyze a company, there are some advice to keep in mind. First, the PEG ratio may or may not be accurate. Using the past earnings growth doesn’t guarantee that it will perform at that rate in the future. There’s no way we are able to know a company’s growth can be slow or speed up. So make sure when using this metric is based on assumption.

In addition, PEG ratio doesn’t take into account of other variables that could add or take away from a company’s value. For example, some growth companies that may have a high PEG ratio might have a lot of cash in the balance sheet. The story changes when we look at the factor in this term.

Last but not least, applying PEG ratio in a slower growing companies or value stocks might be different. If a strong company trading at Price-to-Earning of 18 and has grown 7% per year for decades, this gives a PEG ratio of 2.57 (18/7%). Its PEG ratio might look expensive since it’s not below 1, but this stock could be a good investment if it continues to grow at that pace since it has a good tracking record of good business performance. This come to a conclusion that you still can come up with a good stock investment even though you might have picked a stock that has a high PEG ratio.

5. Debt-to-Equity Ratio (Debt/Equity)
This is the important metric ratio that I use to analyze a company. Using this ratio, I’m able to analyze whether a company is highly leverage (high in debt) or not. A Company’s Debt-to-Equity Ratio is calculated as Total Liabilities divided to all Shareholders’ Equity.

Having debt is not always a negative thing. A company can use debt to increase shareholder returns. If debt is accessible and cheap to borrow, it’s fine for company to have some debts to expand their business. However, you want to look for a company that has low in debt since during harsh time such as in recession or crisis; a company that is highly in debt might go through financial difficulty paying its debt. An example of a company that went under due to acquiring a lot of debt is Sears Holding Corporation. The company filed Chapter 11 bankruptcy on October 15, 2018. There are many lists of companies that went bankrupt due to the large amount of debts they are holding in their balance sheet.

When searching for a company to invest, I personally look for stock that has Debt-to-Equity ratio of less than 0.60 (60%). This debt number sign shows that the company is not highly leverage. Having this metric knowledge gives me the ability to seek for companies that don’t carry high amount of debt which can be risky when investing.  

6. Dividend Payout Ratio
As a Dividend Growth Investor, this is a financial metric that I look at the most. Just looking at a high dividend yield of a stock doesn’t guarantee that you will make that yield each year. If the company doesn’t generate enough profit to keep up with the dividend payout, it might be forced to have the dividend cut or in the worst case scenario to have the dividend stopped. You need to find companies that are able to pay the dividend and maintain paying towards the future.

Dividend Payout Ratio can be calculated as Dividend per Share divided by Earnings per Share. Let’s say a company has Earning-per-Share of $4, and a Dividend-per-Share of $1. This means that the Dividend Payout Ratio is 25% ($1/$4). Using this metric, you are able to see whether the company has sufficient earnings to sustain paying the dividend it promise to its shareholders. A lower dividend payout ratio indicates the company is retaining more cash for its business, whereas a high dividend payout ratio means that they are using most of their earnings to pay dividends to the shareholders.

A payout ratio over 100% means that the company’s dividend payment is outpacing its net income, and it’s not sustainable in the long run. Those whose goal is to collect dividend from dividend growth investing strategy should make sure that the dividend payout ratio is low. This shows that the company has sufficient fund to payout and grow the dividend years ahead.

7. Return on Asset (ROA)
Return on Asset is one of the basic metric that most value investor use to see how profitable a company is relative to its total asset. ROA enables investors, analyst, or manager an idea of how efficient the company can earn using its asset. Return to Asset formula is Net Income divided by Total Assets.

A high ROA indicates that the company has efficient earnings relative to its overall asset. For example, let’s pretend we are comparing two companies that are in the same sector, Company Jackson’s Coffee and Thomas’s Coffee. Jackson spends $1,000 on a coffee machine, while Thomas spends $7,000 on a coffee machine that is higher quality. Let’s assume these are the only thing they spent on and they had their business running for a year. After that year, they both are able to make net profit for their businesses. Jackson’s Coffee was able to make $100 net income in one year, while Thomas’s Coffee was able to make $600 net income in one year. Thomas would have the more valuable business but Jackson would have the more efficient one.

Using the above formula I have provided, we can see Jackson’s Coffee to have a ROA of ($100/$1,000 = 10%), while Thomas’s coffee would have ROA of ($600/$7000 = 8.5%). This ratio gives us the understanding the earnings of the company relative to its overall asset. This is the reason why we should use this formula to compare companies that are in the same sector.

The ROA indicates an idea of how effective the company is converting the money it invests into net income. The higher the ROA number shows the more efficient the company is earning profit. This is because the company is able to earn higher income while using less money on the investment (asset). However, remember that Total Asset is the sum of its Total Liabilities and Shareholder’s Equity. So be wary and cautious about a high ROA return a company has, which assets could be highly leveraged. In other word, the impact of having more debt in the balance sheet should be considered when looking at Return on Asset. Some analyst and investor disregard the cost of acquiring the asset by adding back interest expense in the ROA formula. Interest expense is added since the net income amount on the income statement excludes interest expense. Like the rest of the financial metrics, ROA ratio is just one indication of the company’s performance. You should check other ratios before you feel comfortable in investing in the company.

8. Return on Equity (ROE)
Return on Equity shows how efficient the company is earning using the shareholders’ equity. The formula to this metric is Company’s Net Income divided to Shareholders’ Equity. Since Shareholders’ Equity is equal to Total Assets minus Total Liabilities, it measures how the management is using the company’s equity to generate income. Just by looking at a company’s ROE, it helps investor to recognize whether the company is asset creator or cash consumer.

Let’s take two companies as an example, Company A and Company B that is in the same industry. Company A generates $100 million and has $500 million in shareholders’ equity, while Company B generates $100 million and has $800 million in shareholders’ equity. This result shows company A to have a ROE of 20% ($100m/$500m), while Company B has ROE of 12.5% ($100m/$800m). This shows that Company A is more efficient with its shareholders’ equity.

However bear in mind, unlike ROA, ROE only measures the return on a company’s equity, and does not include the liabilities its holding. This result can make a company have a high return on equity, but having high debt in the balance sheet. The more leverage and debt the company acquire, the higher ROE will be relative to ROA. So its best if you check both ROA and ROE ratios carefully and cautiously to determine which company is efficient or not.

9. Return On Capital (ROC)
ROC is a profitability ratio that measures Earnings before Interest and Tax divided by the Total of Property, Plant and Equipment and Net Working Capital. The equation to this metric is Net Income minus Dividends then divided to Debt plus Equity [(Net Income – Dividends)/ (Debt + Equity)]. For example, Tom’s Taco has $1,000,000 in net income, $5,000,000 in total debt and $1,000,000 in shareholders’ equity. We can calculate Tom’s Taco return on capital using the above equation: [(Net Income – Dividends)/(Debt + Equity) = ($1,000,000 – 0)/($5,000,000 + $1,000,000)= 16.7%].

Return on Capital is also known as “Return on Invested Capital (ROIC)”. This financial metric is often overlooked by investors. ROC is a metric that gauge how well a company generate its cash flow relatively to the capital it has invested in the company. Most investor only uses ROE metric that I mentioned above to evaluate the company’s efficiency of earning profit.

The reason why I use ROC metric as well because if two companies have the same ROE, but one of them have twice more debts; this shows that the management is not generating equal value to the shareholders. ROC evaluates company’s’ earnings to its total capital investment by combining both shareholder equity and total debt. This gives a clearer picture how effective management can produce profits with especially in capital-intensive business.

ROC is usually compared to company’s cost of capital to determine whether the company is creating value for the shareholders. If a company’s ROC is greater than the company’s weighted average cost of capital (WACC), it means the company is creating value for the shareholder. On the contrary it will destroy the value of the company if the WACC is greater than the ROC.

The reason why I like this ratio a lot is because this ratio is considered a magic formula to a value investor named Joel Greenblatt. Joel Greenblatt mentions in his book “The Little Book That Still Beats the Market” that ROC is his magic formula to measure the rate of return a business is making on the total capital used in the company. If you don’t know who Joel Greenblatt is, he is the founder of Gotham Capital. The firm apparently returned over 40% annualized from 1985 to 2006. Using this magic formula has helped him find great companies to achieve the investment return he pursuit.

He mentions why he used ROC just like other metrics such as ROE (Return on Equity) or ROA (Return on Assets). This is because; EBIT (Earnings before Interest and Tax) avoids the misinterpretation arising from the differences in tax rates while comparing to different companies. In addition, net working capital plus net fixed capital is used in place of fixed assets as it shows how much capital is required for the company’s business. Return on capital shows how efficient the company is turning your investments into profits. However, similar to Price-to-Earnings ratio, we shouldn’t just see ROC metric alone. If a company’s ROC is great (high), it doesn’t guarantee it will have the same performance in the future.  

10. Price-to-Free Cash Flow
Free cash flow is crucial measure for understanding the true profitability of a company. The reason why I also use Free Cash Flow is because it’s more difficult to be manipulated and it can tell a better understanding of how a company is performing. You can have a positive net income, however if your free cash flow is negative, it shows how your business is not generating cash flow.

One flaw to the income statement is that it spreads out the cash spent on long-term investments over period of time. For example, if a company called Tom’s Taco purchased $1 million in machine equipment for its business, the expense is spread out over 2 to 3 years on its income statement in the form of depreciation. However, Tom’s Taco doesn’t get to spread out the cash payment for the machine equipment over 2 to 3 years. It has to pay for machine equipment up front as in cash. The income statement is designed to smooth out a company’s uses of cash over time while the cash flow statement is calculated that does not offer smoothing benefit. It’s all about the here and now.

There are several ways to calculate free cash flow. One way to calculate it is Cash Flow from Operation minus Capital Expenditures which equal to Free Cash Flow (Cash flow from Operations – Capital Expenditures = Free Cash Flow). I personally prefer to analyze free cash flow over period of years rather than single year or quarter. This is because I want to see the history of free cash flow over a long period of time rather than a short period term. This way I can tell whether the business have a steady tracking record of cash flow coming in.

Price-to-Free Cash Flow is a valuation metric used to compare a company’s price to its free cash flow. Many people use Price-to-Free Cash Flow as another way to value businesses that are mature. Similar to Price-to-Earnings ratio, Price-to-Free Cash Flow ratios can be a beneficial way in valuing a business. Ultimately, Price-to-Free Cash Flow is just another metric used by value investors, and it doesn’t tell investors everything. However, understanding the difference between net income and free cash flow will make you be a better investor.

11. Price-to-Book (or Tangible Book)
Price-to-Book metrics is a beloved metrics that’s been used by many value investors. To understand Price-to-Book metrics, you’ll need to understand the definition of Book value. Book value is the Net Asset (Total Assets minus Total Liabilities) of the company. Price-to-Book value is important metrics that measures the price of the stock to book value per share (market capitalization/total shareholders’ equity). This ratio helps investors know the price they are paying for the book value per share. Value investors seek for low price-to-book multiples when searching for a bargain company in the market.

In addition, value investors also tend to see the company’s’ price-to-tangible book value since investors want to know the tangible assets that can be sold if a company liquidate its company. For example, Company A has Price-to-Tangible book value of 1, while Company B has a Price-to-Tangible book value of 3. This shows that Company A is worth more since you are paying the same price to its tangible net assets, while you are paying 3 times more for Company B’s tangible net assets. However, always remember that a company with low price to book value tends to have problems with its earning.

Having the advantage to seek companies that are selling under the book value gives investors such as myself to find great deals in the market, but it can also land investors into value traps. One example that I experienced with a company that has a low price-to-book ratio is Game Stop Inc. (Ticker: GME). If you have read my blog, you probably know that I had lost tremendous amount of money ($40,000) in this one investment. The company was trading near its liquidation value; however the company is not profitable like it was in the past. People have changed the way they purchased their games for their gaming device. They used to purchase games from retailers like Game Stop Inc., but the online industry has made consumers to purchase games through online digital distribution platform such as Steam and many other online platforms. In addition, people are also moving to mobile gaming, and the games are not sold from retailers like Game Stop Inc. Instead people can easily purchase those games from the Application Stores according to the mobile device they are using such as Android or iOS. So be wary when using this ratio to seek for undervalued companies. There might be warning reasons why the market has priced the stock cheaply which require you to consider before investing.

In Summary
After listing of all the financial metrics I used to evaluate and value a stock, I hope you readers understand of how I find value in a stock. These are just some basic financial metrics that I frequently used, and there are some other ways to measure a company’s value. Besides measuring the value of a company, you’ll also need to understand the quality of the business to be a better investor. Quantitative measurement is just one part of understanding whether a company is overvalued or undervalued. But to become a successful investor, you are required to make intelligent choice to know whether a company will prosper in the long run. You don’t want to make the same mistake like I did with Game Stop Inc. (Ticker: GME) where the business drastically changes making those financial metrics meaningless. I now understand and appreciate the advice Warren Buffett gave about investing. It is better to invest in great quality company at a fair price than an undervalue company that has trouble coming ahead. Warren Buffett mentioned that his worst investment was actually in purchasing stakes in Berkshire Hathaway which was considered an undervalue company at that time. This shows that the greatest investor had made mistake himself. I believe that by sharing my experience and knowledge on investing makes me learn valuable lessons that are not taught in any universities. From the mistake I made will make me gain experience and knowledge to become a better investor in the future. I as a dividend growth and value investor want to pick on companies that will still be in business in the long run. So I am able to keep my stock positions long term and don’t have to sell them in a hurry. This will give me the advantage of receiving the dividends from my portfolio and have those cash reinvested in great quality dividend paying stocks. With the cash available in hand enable me to buy good stocks at reasonable priced and the companies have long term prospect of growing their business.  

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