Making the decision to buy or sell a stock can be difficult. Ideally, I recommend a thorough analysis of the underlying company’s business, and then a discounted cash flow (DCF) analysis to back out a present intrisic value per share. If the market is offering shares for less than you deem them to be worth, then you buy; if for more, then sell. Real simple, right? Well, not really. I’ll write another blog specifically on this method, but for now I want to focus on some useful shortcuts.

Financial folks call this approach ratio analysis. It involves analyzing some basic metrics on the company’s financial condition. This is by no means a fool-proof method and only shows a snapshot of the larger picture. Nonetheless, here are a few things you should consider when picking a stock:

Profitability Ratios

• Gross profit margin = gross profit / revenue ~ Gives an understanding of how profitable the firm’s core operations are. As a static metric this doesn’t mean much, but analyzing trends over time can give an insight into future prospects or problems.
• Net profit margin = net profit / revenue ~ Incorporates other expenses, including interest and taxes, to show how effective the firm is in translating sales into bottom-line profit
• Return on assets (ROA) = profit / assets ~ How profitable are the assets of the firm? An important measure is the profitability of incremental assets added through capital expenditures. This shoes the efficiency of incremental investments, and gives an indication into the firm’s future prospects. One method for computing this would be to take last year’s (or period’s) capital expenditures (CAPEX) and divide by the change in profit over that period. The flaw in this method is that this assumes previous assets are equivalently profitable to the past period, which is simplistic and ignores either efficiency gains or depreciation.
• Return on equity (ROE) = profit / equity ~ This is arguably the single most important metric for an equity investor, which means anyone who acquires stock. This shows you, as a stock holder, how much of the firm’s profits flow to you, in the form of yield on your investment. The great thing about being a stock investor is that this “equity yield” is not fixed; it fluctuates based on either the firm’s overall profits or the equity base. Ideally, a profitable firm should show increasing profits period-over-period, and either a fixed equity base, a shrinking one (through share buybacks), or at least one that grows at a slower rate than profits.

Liquidity Ratios

A firm’s operations can be highly profitable and yet its business bad to own. This is often the case when companies mismanage their debt, assuming more than they can adequately handle. Some ratios to investigate to ensure this is not the case for the next stock you buy are:

• Current ratio = current assets / current liabilities ~ The term “current” implies that this is the portion of the account that is due within the year. Current assets are things such as cash and accounts receivable, which are both liquid within a one-year timeframe. Current liabilities include such things as accounts payable, and the short-term component of long-term debt. The current ratio shows a rough sketch of the firm’s capability in servicing shot-term liabilities with short-term assets. A good rule of thumb is that you want to see this ratio above 1, but as high as possible. When the ratio is less than 1, don’t panic, analyze the industry structure to see how the competitors fare; this may be normal for that industry!
• Quick ratio = (current assets – inventory) / current liabilities ~ Same measure as the current ratio, but excludes inventory, which is often not as liquid as might be assumed. This is the more conservative ratio to consider.

Leverage Ratios

Businesses require capital and have a few ways to go about raising it. They can either sell equity or borrow through debt issuance. When firm’s borrow to finance the acquisition of assets, they are increasing the risk of their business and providing leverage for equity returns. That being said, debt in-and-of-itself is not bad; in fact, it can greatly increase ROE, so it’s important to understand when enough debt is enough and when firm’s have over-leveraged. Here are few ratios to assist your analysis:

• Debt-to-assets = Total debt / assets ~ Shows the % of assets acquired by debt
• Debt-to-equity = Total debt / equity ~ Shows the general capital structure of the firm. A general rule of thumb is that to reduce risks it is nice to see this ratio to be less than 1. Again, there is nothing inherently wrong with a number > 1, but if so, it would be worthwhile to see how well the firm is capable of dealing with the debt. Check the liquidity ratios and even consider checking the “interest-coverage ratio.”

Some other favorites to help compare one stock with another include the price-to-earnings (P/E) ratio, and the price-to-earnings-growth (PEG) ratio. These two show how much you are paying per normalized dollar in earnings. PEG incorporates the growth rate of those earnings since they fluctuate over time and it may be acceptable to pay more for earnings now if they are going to grow faster. As such, it is generally better to buy stocks with lower P/E and PEG. Generally, you want PEG to be less than 1.

One final word of caution. Markets value assets according to a mulititude of sets of expectations. Just because a firm has a lower P/E than a rival does not mean it is a better value. The market may be pricing it that way rationally because one stock has a better chance for growth over another, or merely a different risk profile. Like I said earlier, this is not easy and there are no set rules to guarantee success.

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