Welcome to lesson two of our course on how to pick stocks! Lesson one looked at setting investment goals, choosing an investment strategy and using screeners and watchlists to find stocks. Lesson two will look at how to analyse those stocks with quantitative analysis . We will cover:

• Using qualitative analysis to analyse company data
• How this data is expressed as ratios
• What these ratios can tell you about the company

By the end of this lesson you should be able to:

• Understand what different raitios tell you about a company
• How to use these ratios to analyse potential investments.

Lets get started!

 

Quantitative Analysis for Stock Picking

Peter Lynch is recognized as one of greatest stock pickers of all time. From 1977 to 1990 he picked stocks for Fidelity Magellan Mutual Fund, increasing assets under management from USD $20 million dollars to over USD $14 billion dollars, posting an average annual return of a phenomenal 29.2%. Lynch famously once referred to stock picking as part art and part science.

The science in stock picking comes from the quantitative analysis of the hard “numbers” a company posts from its financial and operational performance. The art in stock picking comes from the subjective judgment in sorting through the soft, non-tangible aspects of the company’s performance.

Quantitative analysis can be fundamental – focusing on statistical modeling to calculate ratios and metrics from a company’s financial statements – or technical – focusing on stock price movements, trading volumes, and market dynamics.

In this course we focus on the major component of fundamental quantitative analysis most used by retail investors – ratio analysis.

 

Ratio Analysis

Rather than relying on raw numbers from financial statements in isolation, ratio analysis takes two numbers and calculates the relationship between them, expressed in a ratio. There are four main categories of financial ratios.

• Valuation Analysis
• Profitability Analysis
• Financial Health Analysis – Liquidity and Solvency
• Earnings Analysis 

 

Valuation Analysis

There are four principal ratios used in analysing the value of a stock – what it is worth. Al are based on comparing the stock’s current price against financial metrics like earnings, sales, book value, and earnings growth. Professional market analysts search the company’s financial statements to create these ratios, which investors can find on most financial websites and online trading platforms.

The P/E (Price to Earnings) Ratio

This is the valuation ratio most commonly used by investors. The ratio divides the stock’s current share price by its earnings per share. The standard response to the question “what does it mean” is it tells you how much investors are willing to pay for each dollar it earns. Low ratios suggest the stock may be undervalued, while higher ratios may suggest the stock might be overpriced. Another way of interpreting the P/E is as an indicator of the markets expectations for the company’s performance in the future. Low P/Es indicate low growth expectations, in addition to being potentially overvalued. High P/Es indicates the market has high expectations for future growth, in addition to being potentially overpriced.

The P/S (Price to Sales) Ratio

Like the P/E, this ratio tells you how much investors are willing to pay for each dollar the company generates in revenues. While both ratios can be used to compare a stock against competitors in the business sector in which it operates and against the entire investment community as represented by the ASX. The P/S has an advantage over the P/E for early stage companies generating revenue but have not yet turned profitable. Without earnings it is not possible to calculate a P/E.

The P/B (Price to Book) Ratio

This is arguably the most relevant metric for determining whether a stock is undervalued or overvalued. The P/B ratio tells investors how much investors are willing to pay for a company’s net assets. Net assets are the sum total of what a company owns that could be paid to shareholders should the company go bankrupt. Net assets include cash, inventory, buildings, equipment, receivables minus what the company owes – its liabilities.

Like the other price derived ratios, the P/B divides the current  market price per share by the book value per share and can have dual implications. Low P/Bs indicate a company may be undervalued or experiencing some internal difficulty. In essence, a P/B under 1.0 indicates the price of the stock is less than its book value – the net value of its assets included on the company’s balance sheet. A high P/B indicates the market is paying more for it than the company is worth – an indication the stock is overpriced or the market has high expectations for the company’s future.

Value investors will look for stocks with low price-derived ratios while growth investors will gravitate toward stocks with high price derived ratios.

 

Profitability Analysis

Profitability ratios tell investors how efficient the company is at converting its assets into profit. The two main categories of profitability ratios are Margin Ratios and Return Ratios. 

Margin Ratios

Margin ratios compare company profit to revenue. From the financial statements, a company’s Gross Profit is divided by its revenue. This Gross Profit Margin Ratio shows profit available after the cost of good sold is deducted. The Net Profit Margin Ratio divides profit after all expenses, interest, and taxes have been deducted from gross profit. Investors can compare a stock’s margin ratios against competitors and a benchmark index. Higher margins indicate greater efficiency in converting revenues into profit at different states of the company’s operations.

Return Ratios

Return Ratios tell investors how efficient a company is at turning its assets and equity into profits. There are three  important ratios, each focusing on a company’s returns from different inputs. The Return on Assets Ratio (ROA) divides a company’s net income by its total assets., telling investors how efficient the company is at turning resources into profits. The Return on Equity Ratio (ROE) divides net income by shareholders equity – total assets minus total liabilities. This ratio tells the stocks owners – the shareholders – how efficient the company is at turning their money into profit. The Return on Invested Capital Ratio tells investors how efficient a company is at using all sources of capital – both debt and equity. The Inventory Turnover Ratio tells investors how quickly the company converts its inventory into sales. 

Higher ratios are indicators of high efficiency which should turn into higher profitability.

 

Financial Health Analysis – Liquidity and Solvency

No matter the love affair between a hot stock and investors, eventually companies that are not financially healthy will fall. Financially healthy companies need to be both liquid – the ability to fulfill short-term financial obligations from existing cash or assets– and solvent – the ability to meet long-term obligations while remaining financially stable enough to ensure remaining in business over time. 

Liquidity Ratios

There are three important Liquidity Ratios. The Current Ratio indicates a company’s ability to convert assets into cash to meet financial obligations over a one year period. All liquidity ratios are heavily dependent on inventory, as in some industries moving inventory quickly can be problematic. The Quick Ratio takes this into account by subtracting cash and prepaid assets from the company’s available assets. The Cash Ratio is the strictest liquidity measure, using only available cash and assets that can be converted to cash immediately. Liquidity ratios are industry dependent, so comparing with competitors is essential/. Ratios of 1.0 or above and considered adequate, with higher ratios indicating stronger short-term financial capabilities.

Solvency Ratios

There are three Solvency Ratios that measure a company’s financial health in terms of how much the company uses debt to finance operations and assets  – the Debt to Equity Ratio, the Debt to Assets Ratio and the Interest Coverage Ratio. Debt to equity indicates how much a company relies on debt rather than equity to operate. Debt to assets indicates how much a company relies on debt rather than total assets. Investors need to know a company’s ability to make the interest payments on its total debt. The interest coverage ratio takes a company’s earnings before interest (EBIT) divided by its total interest expense. While lower values in debt to equity and assets are desirable indicating the company’s reliance on debt, higher interest coverage ratios point to a company’s margin of safety from its ability to pay interest from earnings.

 

Earnings Analysis

Earnings Ratios evaluate a company’s earnings performance. Earnings per Share (EPS) and Earnings Before Interest (EBIT) are two cornerstone metrics used in other calculations. EPS tells investors how much profit can be traced to each share of common, not preferred, stock. It is tied directly to the P/E as it is the value used to calculate the P/E. Although the P/E remains a dominant metric in stock selection, critics point to a significant flaw with the ratio – it is backward looking. The earnings per share comes from historical earnings from a prior period. Peter Lynch popularized a metric that improved on the P/E – the Price to Earnings Growth Ratio (P/EG). This ratio is forward looking, replacing historical earnings in calculating the ratio with a stock’s expected earnings growth over a time period of anywhere from 1 to 5 years depending on the analyst making the forecasted earnings growth rate. The obvious limitation is forecasts may prove to be incorrect.

The Earnings Yield Ratio is expressed as a percentage giving investors the advantage of comparing stock performance against interest rates and returns from bonds and other fixed income investments. Earnings yield is the inverse of the P/E with EPS divided by current stock price. In contrast to the P/E where lower numbers suggest better value, higher earnings yield suggest a stock is cheap relative to its earnings. Finally, companies losing money will show no P/E but earnings yield will be expressed as a negative percentage.

 

Key Points

• Quantitative analysis relies on measurable numerical data to assess a stock’s future potential. 
• Ratio analysis is a major component of fundamental quantitative analysis.
• Ratios used to assess the value of a stock include the P/E, the P/S, and the P/B.
• Ratios used to assess the profitability of a stock include the Gross Profit Margin and the Net profit Margin along with Return on Equity, Return on Assets, Return on Invested Capital, and Inventory Turnover.
• Liquidity and Solvency ratios like the Current, Quick, and Cash Ratios, the Debt to Equity Ratio and the Interest Coverage Ratios tellinvestors the company’s ability to pay its short-term and long-term financial obligations while remaining solvent long into the future.
• Earnings Ratios like EPS, EBIT, and Earnings Yield tell investors how efficient the company is at generating earnings.

 

Ratios are not meant to be used in isolation. They should be compared to the stock’s historical performance, its competitors, and to benchmark indices like the ASX 200 and the indices for the market sector in which the stock operates.