In this video, we will talk about how to evaluate a stock using all the necessary ratios.
We will focus on 5 parts to evaluate the stock: Valuation / Profitability / Liquidity / Debt and Efficiency.
I will use a real stock example and I will go step by step on where to locate the numbers needed and how to calculate the ratios plus the ideal values for each ratio.
To start I will head to TradingView and pick Apple as the stock to evaluate, but you can apply the same steps to any stock, that is the purpose of this video.
When you start evaluating a stock the first and most important part you want to analyze is the Financial statement of the company. To find the financials of the company click the Financials tab on the toolbar and then click statements. There are 3 Key financial statements you need to read and analyze, the income statement, the balance and the Cash Flow. Given how important each one is and the time it takes to read and analyze them I have created separated videos for each one of them. You can find the video on the cards or on the description below the video.
All the ratios we will calculate, evaluate and analyze today are given by multiplying and dividing numbers we will find on these statements. Having said that, let’s proceed to evaluate the apple stock.
As mentioned , I always begin by reading and analyzing the financials.. Then it’s time for the valuation of the company and to do that you need to calculate certain ratios such as the Price to Earnings ratio.
The price to earning ratio (P/E) ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.
To calculate the Price to earning ratio you need to divide share price with Diluted Earning per share. Using Apple Stock we can find the stock price on the board and the diluted earning per share in the income statement. If we do the calculation the number we will get is around 24 as I divided 147 with 6.05. Always use current numbers which are the TTM, or Trailing 12 month.Investors and analysts consider stocks which have a P/E ratio of 50 or above to be an overvalued share while a stock with a price to earning ratio of 10 or below is considered undervalued.
Another important ratio to calculate while valuing a company is the Price to Book Value. The price-to-book ratio (P/B) is calculated by dividing a company’s market capitalization by its book value of equity or as also known Shareholders Equity. Also, the P/B ratio can be calculated by dividing the latest closing share price of the company by its most recent book value per share.
Let’s calculate the price to book ratio of Apple: The market cap is 2.35 Trillion and the shareholder’s equity which can be found in the balance sheet and is the total assets minus total liabilities is 58.11 Billion. If we do the calculator the result we get is around 40.
A P/B ratio that’s greater than one suggests that the stock price is trading at a premium to the company’s book value. For example, in apples case that has a price-to-book value of 40, it means that its stock is trading at 40 times its book value. As a result, the stock price is considered overvalued relative to its assets. But for large cap stocks that its quite common as investors are willing to pay a premium to invest in these companies.
For companies that pay Dividends we need to take that into account valuing the stock. For those not familiar with the term, A dividend is the distribution of a company’s earnings to its shareholders and is determined by the company’s board of directors. Dividends are often distributed quarterly and may be paid out as cash or in the form of reinvestment in additional stock.
If a company pays dividends we need to calculate the Payout Ratio and the Dividend yield which equals the annual dividend per share divided by the stock’s price per share. TradingView is already providing these numbers for us which is great. For apple the Dividend yield over the years is in decline, and from 1.73% on 2015 note its 0.58%. Overall, a good dividend yield is between 2% and 6% is considered ideal, however it varies depending on market conditions.
The Payout ratio, shows the proportion of earnings a company pays its shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. To calculate it you need to divide the total dividends being paid out with the net income generated. Once more tradingview has done all the work for us, the payout ratio for Apple in 2021 was 15.14 %. A dividend payout ratio of 30-50% is considered healthy, while anything over 50% could be unsustainable.
The next part on evaluating a stock is to check its Profitability.
To determine profitability we will check three metrics: the Return of Assets, the Return of Equity and the Net Profit Margin.
Return of Assets
Starting with the Return of assets, it refers to a financial ratio that indicates how profitable a company is in relation to its total assets. We use Return of assets or ROA to determine how efficiently a company uses its assets to generate a profit. To calculate the ROA we need to divide Net Income with the Total Assets.
You can find the total assets on the balance sheet and the net income on the Income statement or cash flow statement. The metric is commonly expressed as a percentage.
In Apple’s case, and for the year of 2021, the numbers to use are 94.68 Billion divided by 351 Billion. The number you will get is 0.28 or 28%. A ROA of over 5% is generally considered good and over 20% excellent. Keep in mind though, that ROAs should always be compared amongst firms in the same sector. In general a higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits while a lower ROA indicates there is room for improvement.
Return of Equity (ROE)
Return of Equity or (ROE) is a ratio that provides investors with insight into how efficiently a company (or more specifically, its management team) is handling the money that shareholders have contributed to it. In other words, return on equity measures the profitability of a corporation in relation to stockholders’ equity.
To calculate the Return of Equity you need to divide the Net Income with the Shareholders Equity. In apples case for 2021 the numbers are 94.68 Billion divided by 63.09. The number we get is 1.5 or 150%. A return of between 15-20% is considered good.
However, The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing. ROE is often used to compare a company to its competitors and the overall market. The metric is especially beneficial when comparing firms of the same industry since it tends to give accurate indications of which companies are operating with greater financial efficiency.
To note here you can find all these ratios on the statistics page, so let’s compare Apple to Microsoft since they are in the same sector. As you can see, for the year of 2021 Microsoft has a return of Equity 47.08% which is high but quite lower than Apple, meaning Apple is more efficient at generating income.
The Net Profit Margin which is also known as “Profit Margin is the ratio used to calculate the percentage of profit a company produces from its total revenue. It measures the amount of net profit a company obtains per dollar of revenue gained.
To calculate the Net profit margin you need to divide the net income by total revenue.
In Apple’s case these numbers are 99.63 Billion Divided by 387.54 Billion. The number you will get is 0.257 or 25.7%.
A good net profit margin will vary considerably by industry and size of business, but as a general rule of thumb, a 5% margin is low, 10% net profit margin is considered average, and a 20% margin or above is considered high. The higher the number the better.
The current ratio which also is known as working capital ratio measures the liquidity of a company and is calculated by dividing its current assets by its current liabilities. The term current refers to short-term assets or liabilities that are consumed (assets) and paid off (liabilities) in less than one year.
The current ratio is used to provide a company’s ability to pay back its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventory, and accounts receivable).
In Apple’s case for 2021 these numbers are 134.84 Billion divided by 125.48, the number we get is 1.07
A company should ideally have a ratio greater than 1, meaning they have more current assets to current liabilities. However, it’s important to compare ratios to similar companies within the same industry for an accurate comparison.
The quick ratio is identical to the current ratio, except the ratio excludes inventory. Inventory is removed because it is the most difficult to convert to cash when compared to the other current assets like cash, short-term investments, and accounts receivable. In other words, inventory is not as liquid as the other current assets. To calculate the quick ratio you have to subtract inventory from current assets and then divide with current liabilities.
So in our case we need to subtract 6.58 billion from 134.84 Billion which gives as a result of 128.26 Billion , and then have this number divided by 125.48 billion, the final result we get is 1.02.
A ratio value of greater than one is typically considered good from a liquidity standpoint, but this is industry dependent as well.
The next part to focus on is Debt.
Debt is the sum of money borrowed and is due to be paid. To evaluate a company in this department we need to calculate the Debt to Equity ratio and the interest coverage ratio. D/E ratio is an important metric in corporate finance, as It is a measure of the degree to which a company is financing its operations with debt rather than its own resources.It is also known as risk.
Debt-to-equity (D/E) is calculated by dividing a company’s total Debt by its shareholder equity.
In apples case for 2021, we need to divide 136.521 by 63.09, the number we get is 2.16. Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. To note here that Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
Moving on to Efficiency, here we will have to calculate two metrics, Asset Turnover Ratio and Inventory turnover Ratio.
Asset turnover ratio is the ratio between the value of a company’s sales or revenues and the value of its assets. It is an indicator of the efficiency with which a company is deploying its assets to produce the revenue. For this reason, asset turnover ratio is a very important metric evaluating a company’s performance.
To calculate the Asset Turnover ratio you need to Divide Net sales or Total Revenue with the average total assets.
To estimate the 2021 Asset Turnover for Apple you need take the total revenue from the income statement which is 365.82 and divide it by the total assets average of the last 2 years. That would be 351+323.89 divided by 2 which gives us 337.445. If you then divide 365.82 by 337.445 you will get 1.08 which is the asset turnover ratio of apple for 2021.
The higher the ratio, the better is the company’s performance. Asset turnover ratio can be different from company to company. In the retail sector for example, an asset turnover ratio of 2.5 or more could be considered good, while a company in the utilities sector is more likely to aim for an asset turnover ratio that’s between 0.25 and 0.5.
Inventory turnover ratio refers to the amount of time that passes from the day an item is purchased by a company until it is sold. It measures how efficiently inventory is managed.It is important to achieve a high ratio, as higher turnover rates reduce storage and other holding costs.
To calculate the inventory Turnover Ratio you need to divide Cost of od Goods Sold by Average inventory. Once more lets use Apple number, head to the income statement and we can see that the cost of goods sold for 2021 were 212.98 Billion.
For the average inventory head to the balance sheet, the numbers we will use are 6.58 and 4.06. Add these numbers and divide them by 2 , you will get 5.32 Billion.
Now we can divide 212.98 by 5.32 billion and we shall get 40, that means that the inventory turnover ratio for apple for 2021 was 40.
For most industries, the ideal inventory turnover ratio will be between 5 and 10, meaning the company will sell and restock inventory roughly every one to two months. It is vital to compare the ratios between companies operating in the same industry and not for companies operating in different industries.
By now you should have a very good understanding of how to evaluate a stock, or at least to what key metrics you need to look at. To mention once more that it is important to learn how to read and analyze the 3 parts of the Financial report, the Income statement , the Balance Sheet and the Cash Flow.
Combining the Financial Report analysis and the Valuation / Profitability / Liquidity / Debt and Efficiency evaluation we covered in this video, you can reduce the risk of making a mistake picking a stock.
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