When it comes to fundamental analysis—that is, analyzing a company’s underlying financials to determine its investment worthiness—there are dozens of data points worth paying attention to. And between income statements, balance sheets, and statements of cash flows, it can be a lot of information.
This is why we use financial ratios. They help us cut through the noise from pages of documents down to a few key numbers that can paint a broad picture of a company’s financial health. While financial ratios don’t tell the whole story, they can tell a lot of it.
The most popular ratio is price/earnings, or P/E, which measures a company’s price against its earnings per share. In other words, this tells us how much investors are willing to pay for $1 of a company’s earnings.
Though P/E is arguably the most commonly cited of the financial ratios, there are several others that are just as insightful. Here, courtesy of the Chaikin PowerPulse, are five other ratios worth paying attention to.
1) Long-term Debt to Equity
Long-term debt to equity is a company’s long-term debt divided by the total value of equity held by shareholders. This tells us how leveraged a company is, or how much debt it has compared to its total net worth. The higher a company’s long-term debt to equity ratio, the more debt they have. Companies with a lot of debt are generally thought of to be more risky, though it can depend on the industry.
2) Price-to-Book
Price-to-Book ratio, or P/B, measures how much investors have to pay to receive one dollar of a company’s assets. To get P/B ratio, divide a company’s price per share by its book value per share.
P/B tells us whether you’re overpaying or underpaying for a company’s assets, should they go bankrupt. Generally speaking a P/B under 1.0 is considered low, indicating that the company could be undervalued (it could also indicate the company has major problems). The P/B ratio is more useful for companies with liquid assets, like financial firms, and less so for companies that rely on research and development.
3) Return on Equity
Return on equity measures how efficiently a company can turn investors’ money into profits for the company. The formula is net income divided by total shareholder equity.
The higher a company’s ROE the better the company is at generating revenue with the money they have. Growth companies tend to have higher return on equity than value companies. It should also be noted that share buybacks can artificially inflate the number.
4) Price to Sales
Price-to-Sales, or P/S, is a company’s market cap divided by sales over the prior 12 month period. This tells us how much investors are willing to pay for $1 of a company’s sales. P/S is a good alternative to P/E ratio for companies that are not profitable (and therefore don’t have earnings).
Generally, P/S between 1-2 is considered good. Anything below one is considered very good, and anything above three or four is considered bad.
5) Free Cash Flow
Free cash flow measures how much cash a company has left over after all operational expenses have been paid (i.e. leftover cash). The more free cash flow a company has, the more they can invest back into the company, or buy back stock, or pay a dividend.
There are a few different ways to calculate FCF, but the simplest way is by subtracting capital expenditures from operating cash flow.
Free cash flow is one of the most commonly cited financial metrics, simply because of the straightforward way it presents a company’s ability to make money.
A Company With Strong Financials
According to Chaikin Analytics, JP Morgan Chase & Co. JPM has extremely strong financial metrics. The company generates high free cash flow and has a high ROE, indicating that they generate a lot of money and have a lot of leftover cash.
A Company With Weak Financials
Image courtesy of Chaikin Power Pulse
A company with weak financials according to Chaikin Analytics is Microsoft Corporation MSFT. Even though the company has high ROE, they are carrying a lot of long-term debt and relatively low free cash flow.
Image courtesy of Chaikin Power Pulse
Measuring financials is a key way to analyze a company’s underlying health, but it’s only one way. It’s important not to forget about things like earnings and stock performance when determining whether a stock is a good investment or not.
Chaikin Analytics is a content partner of Benzinga.
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