Financial Ratios to Avoid Red Flag Stocks
In a market that seems to have thrown out conventional wisdom, using old measures may leave you uninvested while others continue to enjoy gains in their positions. If you’re off the sidelines and deciding between two or three similar companies, using the most common ratios to orient yourself to reveal the company with more favorable ratios could help you place one stock above another. The ratios do little to determine the company with the better product, better brand, or superior marketing—those factors you can research separately.
More importantly, eyeballing a few easily calculable ratios could allow you to uncover a solid red flag of the companies ability to run the business. One nice thing is, the more useful financial ratios use arithmetic so basic, you don’t have to pull up the calculator app. What takes a bit more thinking is understanding the message a particular ratio delivers.
Ratios to Habitual Check and Compare
Price-to-Earnings Ratio (P/E). This is the price of a share of stock divided by the earnings per share of stock. It’s the amount of money you’d be willing to pay for $1 of earnings.
* If a share of a company’s stock is selling for $40 and the earnings are $2/share, the P/E would be 20. An investor willing to purchase this stock is willing to earn $1 for every $20 invested.
Debt-to-Equity Ratio. The debt-to-equity ratio reveals the debt capital used by the company to finance its operations compared to the equity capital being used. So, if the ratio were 1.0, that would mean that the company’s creditors theoretically have a claim to all of the company’s assets. Nothing
would be left for the shareholders.
* Debt-to-Equity Ratio = (short term debt + long term debt) / shareholders’ equity
Return on Equity (ROE). ROE is the amount of income the company generates contrasted to the amount of shareholder investments. ROE measures how efficiently shareholder investments are used to generate income.
* ROE = Net income / total shareholders’ equity
Return on Assets (ROA). ROA is net income divided by total assets. It’s a measure of how effectively a company can turn its assets into income. For example, a computer screen sitting in a closet is an asset, but it’s not generating income for the shareholders. The same can be said for unnecessary equipment, marble lobbies, and other luxuries.
*Return on Assets = Net Income/Total Assets
The Current Ratio. This ratio is a measure of a company’s current assets versus its current liabilities. A high ratio suggests that a company has plenty of cash and liquid assets on hand to deal with any bills. Understanding why the current ratio is high is important. It could be misleading, for example, A warehouse full of dated inventory can raise the ratio and be a sign of trouble.
* A low current ratio suggests that the company could struggle to meet its short-term liabilities and suffer from a shortage of cash.
Net Profit Margin. Is calculated by dividing the net income by the net revenue. This is the amount of profit generated by each dollar of sales. Some companies make much more profit per $1 of sales than others. Real estate and health care are often mentioned as industries with high-profit margins. This is one place where comparison within the industry is even more critical.
Dividend Yield. It’s also called the dividend-price ratio, dividend payments can be viewed by investors as a cash flow to investors. Companies with a higher dividend yield have the potential to be more attractive to investors than those with lower yields.
*Dividend Yield = = (dividend per share / price per share)
It’s the Extra Step that’s Worthwhile
Financial ratios are important for all investors to grasp, and at a minimum, develop favorites that you consistently check before making an investment. Most research reports on
companies will also post pertinent ratios covering the date of the reporting period. The results can uncover red flags and may place one investment option more favorably in your mind for decision-making. It’s not possible to successfully make investing decisions with financial ratios alone, but these ratios are an excellent part of a prudent process.
Suggested Reading:
Why Researching Investment Ideas is Important
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