6 Financial Ratios for Stock Analysis: Evaluate Companies Like a Pro

Effectively evaluating stocks is critical for making informed investment decisions. Financial ratios are powerful tools that help investors assess a company’s performance, financial health, and valuation. By understanding and utilizing these ratios, investors in the Philippines can analyze companies like professionals. This comprehensive guide explores six essential financial ratios, providing in-depth explanations, calculation methods, interpretation guidelines, and practical applications.

Valuation Ratios: Understanding Company Worth

Price-to-Earnings (P/E) Ratio

The price-to-earnings (P/E) ratio is one of the most widely used metrics for valuing a company. It compares the current share price to the company’s earnings per share (EPS).

Formula and Calculation

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P/E Ratio = Market Price per Share / Earnings per Share (EPS)

How to Interpret P/E Ratio

• High P/E Ratio: Indicates that investors expect high growth in the future. Companies with strong growth prospects often command higher P/E ratios.
• Low P/E Ratio: Could indicate an undervaluation of the stock or difficulties facing the company. Value investors often look for companies with low P/E ratios relative to their industry or historical levels.
• Industry Comparison: Always compare a company’s P/E ratio to others in the same industry, as different sectors have different typical P/E ranges.

Real-World Application

• A company with a P/E ratio of 15 indicates that investors are willing to pay PHP 15 for every PHP 1 in earnings.
• In the Philippine context, companies in high-growth sectors like technology might have P/E ratios of 20-30, while more established industries like banking might have lower P/E ratios of 10-15.

Limitations

• P/E ratios don’t account for company debt levels
• They can be misleading for companies with irregular earnings
• Companies with negative earnings don’t have a meaningful P/E ratio

Price-to-Book (P/B) Ratio

The price-to-book (P/B) ratio compares a company’s market price to its book value (net asset value).

Formula and Calculation

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P/B Ratio = Market Price per Share / Book Value per Share

How to Interpret P/B Ratio

• P/B < 1: Suggests a potential undervaluation of the stock. The market values the company at less than the accounting value of its assets.
• P/B > 1: Indicates that the stock analysis may be overvalued or that the company has robust growth prospects. Investors are willing to pay a premium over the company’s net asset value.
• Industry Specific: Different industries have different capital requirements and expected P/B ratios.

Real-World Application

• A P/B ratio of 0.8 means the stock analysis is trading at 80% of its book value.
• Property companies and banks in the Philippines often trade at P/B ratios closer to their book value due to their asset-heavy nature.

Advanced Analysis

• Compare P/B with Return on Equity (ROE) for a more comprehensive analysis
• Examine trends in P/B over time to identify potential investment opportunities
• Consider the quality of assets on the balance sheet

Financial Health Ratios: Assessing Company Stability

Debt-to-Equity (D/E) Ratio

The debt-to-equity (D/E) ratio measures a company’s financial leverage by comparing its total liabilities to its shareholders’ equity.

Formula and Calculation

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D/E Ratio = Total Liabilities / Shareholders’ Equity

How to Interpret D/E Ratio

• High D/E Ratio: Indicates higher financial risk due to increased debt levels. Companies with D/E ratios above 2.0 may face higher interest expenses and financial vulnerability.
• Low D/E Ratio: Suggests a more conservative approach with less reliance on debt. A D/E ratio below 0.5 often indicates financial stability.
• Industry Considerations: Capital-intensive industries typically have higher D/E ratios than service industries.

Real-World Application

• A D/E ratio of 0.5 means the company has PHP 0.50 of debt for every PHP 1 of equity.
• In the Philippines, utilities and telecommunications companies often operate with higher D/E ratios due to their stable cash flows and capital requirements.

Risk Assessment Framework

• Evaluate D/E alongside interest coverage ratio for comprehensive debt analysis
• Consider debt maturity profiles and refinancing risks
• Assess debt denomination (PHP vs. foreign currencies) for exposure to exchange rate fluctuations

Current Ratio

The current ratio assesses a company’s ability to pay its short-term obligations with its short-term assets.

Formula and Calculation

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Current Ratio = Current Assets / Current Liabilities

How to Interpret Current Ratio

• Current Ratio > 1: Indicates that the company is able to meet its short-term obligations. A ratio of 1.5-2.0 is generally considered healthy.
• Current Ratio < 1: Indicates potential liquidity problems. The company may struggle to meet its short-term obligations.
• Trend Analysis: The trend of the current ratio over time is often more revealing than a single value.

Real-World Application

• A current ratio of 2 means the company has PHP 2 in current assets for every PHP 1 in current liabilities.
• For retailers in the Philippines, seasonal fluctuations in inventory can affect the current ratio throughout the year.

Enhanced Liquidity Analysis

• Compare with the quick ratio (excludes inventory) for a stricter liquidity test
• Examine cash flow statements alongside the current ratio
• Assess quality and liquidity of current assets

Profitability Ratios: Measuring Efficiency and Returns

Return on Equity (ROE)

Return on equity (ROE) measures a company’s profitability by comparing net income to shareholders’ equity.

Formula and Calculation

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ROE = Net Income / Shareholders’ Equity

How to Interpret ROE

• High ROE: Indicates efficient use of equity to generate profits. An ROE above 15% is generally considered good.
• Low ROE: Suggests less efficient use of equity. Companies with ROE below the industry average may be underperforming.
• DuPont Analysis: Breaking down ROE into profit margin, asset turnover, and financial leverage provides deeper insights.

Real-World Application

• An ROE of 15% means the company generates PHP 0.15 in profit for every PHP 1 of equity.
• In the Philippine market, well-managed banks often maintain ROEs between 10-15%.

Strategic Interpretation

• Compare ROE to the company’s cost of equity to assess value creation
• Analyze ROE trends over multiple years to identify sustainable performance
• Consider the impact of one-time events on ROE calculations

Dividend Yield

The dividend yield indicates the annual dividend payment as a percentage of the stock’s current price.

Formula and Calculation

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Dividend Yield = Annual Dividend per Share / Market Price per Share

How to Interpret Dividend Yield

• High Dividend Yield: Attractive for income-focused investors, but could indicate a high-risk stock analysis or limited growth prospects if significantly above market average.
• Low Dividend Yield: Indicates lower dividend income but possibly higher growth potential. The company may be reinvesting profits for future growth.
• Payout Analysis: Consider the dividend payout ratio alongside the yield for sustainability assessment.

Real-World Application

• A dividend yield of 4% means the company pays PHP 4 annually for every PHP 100 invested in the stock.
• Philippine telecommunications and utility companies often offer higher dividend yields, sometimes ranging from 4-6%.

Dividend Strategy Considerations

• Evaluate dividend growth history and consistency
• Assess the company’s free cash flow to support dividend payments
• Consider the impact of special dividends on the calculation

Integrating Financial Ratios into Investment Analysis

Sector-Specific Considerations

Different industries have different “normal” ranges for financial ratios. Understanding sector-specific benchmarks helps place individual company ratios in context.

Banking Sector

• Focus on net interest margin, loan-to-deposit ratio, and non-performing loan ratio
• Lower acceptable P/B ratios compared to other sectors
• Capital adequacy ratios as regulatory requirements

Manufacturing Sector

• Inventory turnover and accounts receivable turnover become critical
• Higher capital expenditure needs reflected in balance sheet ratios
• Operational efficiency ratios like gross margin

Property Sector

• Net asset value per share is a key valuation metric
• Recurring income vs. development income analysis
• Debt service coverage ratio for financial stability

Combining Ratios for Comprehensive Analysis

Growth and Value Assessment

• Compare P/E ratio with the company’s earnings growth rate (PEG ratio)
• Assess P/B ratio alongside ROE to identify potential value opportunities
• Evaluate dividend yield in relation to earnings growth

Financial Stability Framework

• Analyze D/E ratio together with interest coverage ratio
• Compare current ratio with industry cash conversion cycles
• Assess working capital management efficiency

Performance Evaluation Matrix

• ROE in conjunction with profit margins and asset turnover
• Dividend yield alongside dividend payout ratio and earnings retention
• Capital allocation efficiency metrics

Practical Application in the Philippine Market

Using Ratios to Screen Stocks

• Setting ratio thresholds for initial stock screening
• Creating a ranking system based on multiple financial ratios
• Building watchlists of companies meeting specific criteria

Comparative Analysis Techniques

• Comparing a company’s ratios to industry peers
• Tracking ratio trends over multiple quarters and years
• Benchmarking against market leaders and sector averages

Red Flags and Warning Signs

• Sudden deterioration in key financial ratios
• Inconsistencies between related ratios
• Ratios that significantly deviate from industry norms

Conclusion

Understanding and applying these financial ratios can help Filipino investors make more informed decisions and evaluate companies more effectively. By analyzing the P/E ratio, P/B ratio, D/E ratio, current ratio, ROE, and dividend yield, investors can gain insights into a company’s valuation, financial health, and profitability.

These ratios should not be used in isolation but rather as part of a comprehensive investment analysis framework. Consider industry specifics, company growth stage, management quality, and broader economic conditions alongside financial ratios. Regularly using these ratios in your investment analysis can enhance your ability to identify attractive investment opportunities and build a robust portfolio tailored to the Philippine market.

Remember that historical ratios are backward-looking, while investing is forward-looking. Use these tools to inform your decisions, but also consider qualitative factors and future prospects when evaluating potential investments.

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