10 stock analysis ratios used by the pros

Earnings per Share (EPS)

Earnings per share is the net profit per share outstanding. It is used to judge the profitability of a single company and is a key element in the Price-to-Earnings ratio.

EPS can be calculate using two methods; basic and diluted. Diluted EPS takes into consideration the impact of warrants, stock options and convertible securities when calculating EPS and is more commonly used.

Formula:

EPS = Net Income/Number of Share Outstanding

Price-to-Earnings Ratio

One of the most commonly used metrics to analyse and compare a stock’s valuation.

This ratio values stocks is in terms of their net earnings.

There are different variations of Price-to-Earnings (PE) to reflect the period of earnings. A trailing PE ratio uses the previous 4 quarter’s earnings whereas a projected PE ratio uses analyst estimates for the next 4 quarters of earnings.

Projected or forward PE ratios are widely used in analysis as it is most useful for forecasting future share prices.

PE ratios are effective at analysing stocks within the same sector but not so much for those in different industry groups. For example, technology stocks generally have a higher PE than utility stocks due to the perception of higher growth within the industry.

Investors are willing to buy stocks with a higher PE if there is a strong potential for growth and higher earnings in the future but usually see more value in those with a lower PE

Formula:

PE Ratio = Market Capitalisation/Net Income

or

PE Ratio = Market Value per Share/Earnings per Share

Price-to-Book

This ratio focuses on what would be retained if the business was sold off immediately. It takes the total assets and subtracts the total liabilities to produce the ‘book’ value, the amount that would be left if everything was liquidated.

Note that intangible assets (brands, patents) are ignored in the book value as they are difficult to value and sell.

A lower Price-to-Book will be attractive as an investor will not be paying too much for the potential left overs of a company in the case of bankruptcy.

Formula:

Price-to-Book= Market Capitalisation/Book Value

Price-to-Sales

As with all ratios mentioned, Price-to-Sales is most useful when comparing companies in the same industry group.

Earnings may be small or non-existence in young companies or those in the midst of a period of rapid growth.

Price-to-sales takes the top line revenue as the denominator in this ratio to focus on the cash generating capabilities of a company.

Formula:

Price-to-Sales Ratio = Market Capitalisation/Revenue

Or

Price-to-Sales Ratio = Market Value per Share/Sales per Share

Return on Equity

This is a key measure of efficiency. In crude terms, it is a measure of how well the board of a company is putting your money to work.

A higher ROE indicates that the business is generating a higher proportion of profit for the resources they have at their disposal.

It is extremely useful when comparing companies in the same industry but not so much inter-sector due to the difference in capital requirements.

Formula:

Return on Equity = Net Income/Shareholder Equity

Debt-to-Equity

This is a key measure of a business’s leverage. It highlights the amount of debt a company has created to fund operations.

Those with high Debt-to-Equity will have to pay higher interest payments, if these payments become too much and exceed returns from ongoing activities, it can lead to bankruptcy.

Formula:

Debt-to-Equity Ratio = Total Liabilities/Shareholders Equity

Free Cash Flow

A barometer of a firm’s solvency, Free Cash Flow highlights a business’s ability to deal with sudden shocks and whether it is able to finance expansion from its current operations.

Formula:

Free Cash Flow = Cash Flow from Operations – Capital Expenditure

Weighted Average Cost of Capital (WACC)

WACC is effectively the cost of a business’s assets. A company’s capital is usually funded by two components; equity and debt.

A business will have to compensate the holders of these assets which, in a nutshell, is the Weighted Average Cost of Capital.

Any activities or projects undertaken by the business must produce a return in excess of WACC to produce a profit.

Often overlooked by many investors, WACC is a basic measure of a business’s costs and therefore a key element in estimating the net present value (NPV) of a project or a business. WACC is taken from future cash flows to calculate NPV.

The higher the WACC, the more a company is required to make from operations leaving less room for error, therefore companies with a higher WACC are higher risk than those with lower WACC.

Formula:

WACC = (cost of equity x (market value of equity/market value of equity + market value of debt)) + ((cost of debt x (market value of debt/market value of equity + market value of debt)) x 1- Tax Rate)

Enterprise Value (EV)

The enterprise value of a business is considered a more effective method of valuing a business than the standard market capitalisation of shares outstanding in the case of an acquisition.

Enterprise value is effectively what a buyer would get if a company was to be bought.

Debt, cash, preferred shares and minority interest are used in the calculation of the enterprise value as they would have an impact on what potential acquirer would end up with.

When a company is bought, the acquirer will receive the cash and have to pay off the debt.

Although preferred shares are equity, they have similar attributes to debt in as far as preferred shares’ dividends are fixed and are ranked above common equity.

Minority interest accounts for any of the business that is owned by another company and will not be received by the acquirer of the business.

Formula:

Enterprise Value = Market Capitalization + Debt + Preferred Share Capital + Minority Interest – Cash

Enterprise Value/Earnings before Interest, Tax, Depreciation and Amortisation

Just as the Enterprise Value is a better indication of a business’s true value if it were to be bought, the EV/EBITA is seen as more useful method of valuation than Price/Earnings in the case of an acquisition.

As EBITDA focuses on the operating cash flows and leaves out the impact of depreciating assets, interest paid on debt and taxation thus EV/EBITDA provides a valuation that is useful for a potential acquirer.

A low EV/EBITDA will highlight a strong target for an acquirer.

Formula:

EV/EBITDA

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