When the first steps are taken in the world of investments and stock analysis is not uncommon to find, in articles, websites or manuals, measures and ratios that are not intuitive or easy to understand at first glance.
However, they are a very important subject to understand in-depth, because they say a lot about the company they are related to.
In fact, it is physically impossible to analyze the balance sheet, and financial statement of every company on the stock market, therefore we need to make a “preselection”, where, by using a stock screener (like those available at finviz.com, investing.com, etc.), we can go through a list of all the stocks listed on the major stock exchanges in the world.
Thanks to these screeners, we can group, rank, and select companies based on key data or characteristics that we think are more relevant than others, and by using these main measures you will be able to identify companies that are worth a more accurate analysis.
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Price to Earnings Ratio (P/E):
It is the most used and known measure, especially in the world of value investing, it is the measure of the share price relative to the annual net income earned by the firm per share.
A high PE ratio generally indicates increased demand by investors, it could mean that the stock is overvalued, or on the other hand, that investors are expecting high growth rates in the future. The PE ratio has units of years, which can be interpreted as the number of years of earnings to pay back the purchase price.
Given that the denominator is the EPS (Earnings per Share), companies that have no earnings or that are losing money do not have a P/E ratio.
There is not a precise level where a P/E ratio can be considered high or low, it depends a lot on the industry and the type of company you are analyzing, therefore is important to know how a certain market works, and how the companies that work in that environment are valued. However, usually a P/E under 20 can be considered ok.
Price to Earnings Ratio = Price / Earnings Per Share (EPS)
There are also two additional kinds of P/E ratio:
- Trailing P/E ratio, which relies more on past performance by dividing the current share price by the total EPS earnings over the past 12 months. Even though it is the most popular P/E metric, it is important to keep in mind that past performance doesn’t determine future growth.
- Forward P/E ratio, which on the other hand uses future earnings guidance rather than trailing figures. It is a forward-looking indicator that may help to provide a clearer picture of what earnings may look like in the future. However, this measure has different inherent problems, related to the fact that companies may underestimate or overestimate future earnings.
Price to Book Ratio (P/B)
The price to book ratio is composed by dividing the price per share by the book value per share. The company’s book value is its carrying value on the balance sheet, it can also be thought of as the net asset value of a company calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
Price to Book Ratio = Price / Book Value per Share (BVPS)
Generally, a low P/B ratio could mean that the stock is undervalued, but it could also mean something is fundamentally wrong with the company.
Moreover, as with most ratios is hard to determine if a certain level the P/B ratio is low or high, it varies by industry, and by the financial structure of a company.
The P/B ratio of companies that are active in areas where the core of its activity is related to intangibles, like tech companies, or services companies, the book value will be lower and therefore the P/B ratio may be very high even though the company may be undervalued.
A similar thing may happen when dealing with a company that has a high debt level, in fact, a high indebtedness leads to lower book value and therefore a high P/B value, and therefore an overvalued company.
I really like looking at P/B ratio, because finding companies that are trading at a price that is lower their book value gives a higher chance of making good returns.
The P/B ratio also indicates whether you’re paying too much for what would remain if the company went bankrupt immediately.
Free Cash Flow (FCF)
It represents the amount of cash that a company generates after accounting for cash outflows that happened to support operations and maintain capital assets.
It is a way of looking at the cash flow of a company to see what is available for distribution among all the stockholders, therefore it is useful for investors that are deciding whether to invest in the company or not, to understand how much cash can be extracted from a company without causing issues to its operations.
Unlike P/E that looks at the company’s earnings, Free Cash Flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets from the balance sheet.
As with the other two measures we have seen before, even with FCF is hard to say in absolute terms what is a good FCF value and what is a bad one. However, one common approach is to look at its trend, as a measure of risk.
Therefore, if it is stable or it is increasing, the risk is considered to be lower overall, while on the other hand, if the FCF trend falls, it is a sign of greater risk, and indicates a higher likelihood of negative price performance in the future.
As I already said in the introduction, these are not the only measures available to evaluate a stock and decide to invest, but they are among the most used and are very useful because, by looking at them you can easily understand if a company is worth a more in-depth analysis, or if it is not interesting to you and to your strategy.