Why Fundamental Analysis is essential in your investment journey
How smart investors pick the right stocks using financial ratios.
It’s a known fact that investors are hooked on seeking the next rewarding stock recommendation. But there’s a problem. The sheer number of companies in the equity market can be overwhelming and may leave you confused.
However, there is a way out. You can narrow down your long-term investing choices by simply applying the tried-and-trusted practice of fundamental analysis.
Let’s jump right into it.
Financial ratios offer investors a means to evaluate a company’s performance and compare it to similar businesses in its industry. It also helps investors find stocks trading lower than their true value.
While fundamental analysis and ratio analysis may not guarantee a company’s future performance, it certainly serves as a useful tool to analyse the financials of a company, an industry, or an index.
Watch our Webinar: How to pick the right stocks using Fundamental Analysis
Here are some of the key investment ratios to help you better undertake fundamental analysis easily:
1. Price-to-Earnings (P/E) Ratio
It indicates whether the market price of a stock reflects the company’s earnings potential or true value, and helps investors determine if it is under or overvalued.
Example
Let’s assume that Company K’s stock is currently trading for $50 and its most recent income statement showed that it generated $5 in earnings per share (EPS).
P/E Ratio: $50/5 = 10
*Meaning that investors pay $10 for every $1 of earnings generated by the company. Should be less than the industry average or that of the S&P 500.
2. Return on Assets (ROA)
Expressed as a percentage, this financial ratio indicates how much profit can be derived from each dollar of assets owned by the company.
Example
Let’s assume that Company A reported $10,000 of net income and owns $100,000 in assets.
ROA: ($10,000/$100,000)*100 = 10%
*In general, a ROA above 5% is considered good.
3. Return on Equity (ROE)
Expressed as a percentage, this key financial ratio indicates how much profit is generated for each dollar of shareholders’ equity.
Example
Let’s assume that Company B reported $10,000 of net income and its shareholders have $200,000 in equity.
ROE: ($10,000/$200,000)*100 = 5%
*While averages can vary depending on the industry, and ROE above 10% is generally considered good.
S&P 500 Return on Equity (2014 till date)
4. Current Ratio
Expressed as a numerical value, the ratio indicates how many times current liabilities can be covered by current assets.
Example
Let’s assume that Company D holds $100,000 in current assets and has $50,000 in current liabilities.
Current Ratio: $100,000/$50,000 = 2
*Above 1 is considered good. It indicates that the company has more current assets than current liabilities.
5. Debt Ratio
A measure of a company’s debt in relation to its assets.
Example
Let’s assume that Company G has $100,000 in total liabilities and $200,000 in total assets.
Debt Ratio: $100,000/$200,000 = 0.5
*With a debt ratio of 0.5, meaning its debt accounts for half of its assets.
6. Debt to Equity Ratio (D/E)
A measure of a company’s debt in relation to its equity.
Example
Let’s assume that Company H has $100,000 in total liabilities and $50,000 in total shareholders’ equity.
Debt to equity ratio: $100,000/$50,000 = 2
*Debt to equity ratio of 2, meaning that it has twice as much debt as equity. I.e the company relies on debt to finance its operations — and that its shareholders’ equity would not be able to cover all of its debts.
7. Dividend Yield
Dividend yield is a useful financial ratio that measures a company’s annual dividend payouts relative to its stock price. For investors who prioritize dividend payouts over capital gains, the dividend yield is a way of measuring return on investment.
Example
Let’s assume that Company O’s stock is currently trading for $20. Its most recent income statement showed that it paid $1/share in dividends.
Dividend Yield: ($1/$20)*100 = 5%
*Vary between companies and industries, a dividend yield between 2% to 5% is generally considered good.
8. Gross Margin Ratio
It shows how much profit a company makes after paying off its Cost of Goods Sold (COGS).
Example
If the ratio is calculated to be 20%, that means for every dollar of revenue generated, $0.20 is retained while $0.80 is attributed to the cost of goods sold.
*Above 10% is good enough
What’s The Takeaway?
The market is full of sweet unverified tips and doomsday stories. As such, it is important to look at the fundamentals and value of any company before you decide to invest.
Truth is, you do not need not know a lot to make quality decisions, as long as these decisions are based on fundamentals. Basic knowledge of the ratios listed above will help you make informed investment decisions and build real wealth from the markets.
For a more detailed breakdown and expert opinions on this topic, watch our webinar on How to pick the right stocks using Fundamental Analysis. Click here to watch.
