We’ve all been there. Confidence is growing, you’ve built up a solid portfolio of passive funds which have been performing well. You’re ready to take the plunge and buy your first stock. You look up the name on Yahoo Finance, or Marketbeat, or MarketWatch (all decent places to start gathering data) and what do you see?
Pages and pages of ratios. All of them in acronyms and barely explained. P/S, P/B, P/E, PEG are just the ones starting with P, let alone D/E, the Quick Ratio, the Current Ratio, Enterprise Value to EBITDA.
I’ve some good news for you. You don’t need to know what all of them mean. In fact, various studies (for example this one) have shown that increasing information doesn’t necessarily increase the accuracy of predictions, it only increases confidence in those decisions. We love when new data confirms what we already believe and are only too ready to discard data that doesn’t. This works in our favour. We don’t need to choose 40 ratios to review, we only need to choose the best few.
One small caveat before we get started – investing in individual stocks is risky. By investing in a stock, you’re implicitly claiming to understand its true value better than the wider market. You might be right, but bear in mind that you’re competing with financial professionals every time you buy an individual stock. The markets do not create money, if you’re making great returns somewhere, someone else is making poor ones. As such, I would recommend starting out with only 5-10% of your portfolio in individual stocks. If you do well, you can consider ramping it up, but in this bloggers humble opinion, you should max out at 20%. Like in a casino, in the end the house (Mr Market) always wins, and the best way to win with him is with tracker/index funds.
Ratio #1: The King of Ratios, P/E
When I look at stocks, I’m trying to answer three key questions:
- Will this company survive long enough for me to make money out of it?
- Is this company expensive or cheap given its market/prospects?
- Does the growth of this company justify the current price?
These questions are all interconnected, a company that’s about to go bankrupt will probably not be expensive (probably, I’m looking at you Gamestop). A company that is making a ton of money every quarter will probably not be cheap.
So, to the P/E ratio. P/E stands for Price (per share) to Earnings (per share). Its best explained as the ratio of how much it costs a buyer (you) to buy a single dollar of a companies’ earnings. Let’s unpack that.
In the end, what a company is worth, from a theoretical standpoint, is the present value of all of the money it gives its shareholders from now into the future. If the P/E of a oil major is 11.0 then you have to pay £11 per each £1 of the oil major’s earnings. If the P/E of an hot shot tech company is 40.0, you have to pay £40 for the same £1 of earnings.
The choice here feels obvious right? Buy the cheap one! To some extent this is true, a lower P/E is better because you’re buying one £1 of earnings for less. A good rule of thumb to get an idea of the relative value of this ratio is to compare the P/E to that of its market (e.g. for the oil major this would be the FTSE 100) or its peers (the other oil majors, including those in other countries). However, we’re not yet done, as plenty of people buy stocks with high P/E ratios. After all, this is how they got high in the first place! This is where growth expectations come in…
Ratio #2: The Expansion, PEG
Now we zoom in on question number three:
“Does the growth of this company justify the current price?”
If the price of a stock is the total of all the returns you expect to receive from now into the future, then future returns, potentially returns well into the future (5, 10, 20 years on) will have a big impact on how much a share might be worth. So what’s the single factor that has the biggest impact on these future returns? Growth.
Here we come back to the miracle of compounding, a company growing at 10% every year will be 2.6x larger in ten years than it is today and, due to economies of scale, potentially able to produce more than 2.6x the amount of earnings. This is how investors justify high prices in the present (like those of the tech stocks at the time of writing). The assumption is that they will earn bumper earnings in the future (and start paying dividends or buyback increasing amounts of stock) thus justifying their sky high valuations.
The PEG ratio, or the Price to Earnings to Growth ratio, is an attempt to include growth expectations in the P/E ratio. The way it does this is to take the P/E ratio and divide it in turn by the growth expectations of the stock. Now, growth expectations are a tricky concept, after all, past growth doesn’t equal future growth. In general, people often keep it simple here with:
- a trailing PEG
- the P/E divided by the last years growth in Earnings per share or;
- the forward PEG
- the P/E divided by the next years growth in Earnings per share.
The higher the growth rate and the lower the P/E, the lower the PEG. The inverse is also true: the lower the growth rate and the higher the P/E, the higher the PEG. A good rule of thumb for the PEG is that lower than 1 is good value (e.g. a P/E of 15 and a growth rate of 17% which would be a PEG of 0.88).
Unfortunately, in todays market, you’ll be lucky to find many PEGs below one (given where pricing is) but lower is still better!
Ratio #3: A quick test: Debt to Equity
We’ve found a few ratios to get some insight into how expensive we view a possible investment to be and whether it might be worth it nonetheless. So lets now turn to the first question:
Will this company survive long enough for me to make money out of it?
This is a big question. If a company fails, of all the parties that may have given it money (banks, customers, bond holders, equity investors) its the equity investors that get paid last and are thus most likely to lose money, or even to be wiped out entirely.
Luckily, this is also fairly unlikely for quite a few companies but and this is key, not for all. You may have heard of “Zombie” companies in the news, those that don’t make enough money to cover their debts and can only survive by issuing more debt. Some investors hold the equity in these companies. I would not recommend that, no matter how cheap they may seem. As soon as the music stops, and these companies can no longer access capital, they will fail.
So, how do we avoid the Zombies? How do we avoid the companies that are at risk of failure?
The first thing to do is check how they are financed – is it via debt or via equity? This is an important (and deceptively complex) question. There are many reasons to be financed by both (debt is typically cheaper as a source of capital, returns are amplified by higher debt levels, potentially it makes management more disciplined) but using very high levels of debt and very low equity may mean big returns in the short term, but could be bad news over the longer term.
Here we come to a very simple ratio which tells us quite a bit, the debt to equity ratio. You simply divide the total debt on the balance sheet by the total equity. If the number is below 1, the company has more equity than debt, if the number is over one vice versa. If the ratio is well over one, there’s a big red flag and its worth doing some more due diligence to make sure you know why.
Ratio #4: The money machine: ROE
Its a simple question: if I give your company some money, how much more money are you going to make using it?
The way we figure this out is by looking at the Return on Equity. The point to remember here is that the Equity in this calculation is the portion of the companies assets that are “owed” to its owners. When you buy a share in a company, you are joining its owners, albeit a very small one!
At the most basic level, equity investing is giving someone money, so they can make more money. This can be a friend who wants to open up a hairdresser. This can be a chain of stores that want to expand. Or this can be a massive car manufacturer where your money will buy part of a complicated car building robot. The question is, who will make the most money on your money?
Its tempting to say the car manufacturer right? Potentially, but your investment is a tiny proportion of their overall capital, its likely not going to make a big difference. Whereas investing money with your hairdresser friend could mean you make huge returns if they turn out to be the next Vidal Sassoon and you get in at the ground floor.
From a ratio perspective, we look at this by dividing a companies net income (its profits after all expenses, interest, tax etc) by its average equity (as this will move over the year). The higher the better, as this means the company is putting your money to good use.
Though beware that debt boosts this ratio. Think of it this way, debt increases the amount of capital a company can invest without increasing the amount invested. For example, rather than purchasing one salon, your friend takes your money and uses it as a down payment on three hairdresser salons with a mortgage making up the rest . If it goes well then you get your share of the profits from three salons instead of one! However, your friend now needs to keep up with three mortgages so the chance of failure is much higher.
Ratio #5: The Acid Test
“There are decades where nothing happens; and there are weeks where decades happen.”
Lenin, yes really
Putting aside the absurdity of quoting Lenin on a blog about how to get rich via winning the game of capitalism, markets don’t move steadily in one direction or another. There will be long period where markets will slowly increase interspersed with weeks where 15% is lost or gained incredibly rapidly and, finally, by years of crushing underperformance. Its in this latter case that we need to be sure our investments will survive.
The key variable we’re looking at here is a concept called Liquidity. Much like owning a house doesn’t help you to pay for a can of coke when you’ve forgotten your wallet (/phone for the youth), a chain of high performing factories won’t help a company stay afloat if it doesn’t have enough capital to pay its employees and suppliers.
The ratio to look at this is called, compellingly, the Acid Test ratio. Its calculated as:
For this one, you don’t need to calculate it yourself from the financial statements, you can find it pre-calculated on many financial data sites.
What its seeking to identify is whether the short term liquid assets of the company (the “liquid current assets”) are more than the short term money it owes (the “current liabilities”) at any point in time. I.e. if it had to settle all its short term debts tomorrow, would it be able to?
As I’m sure you’ve already worked out dear reader, this is the second ratio seeking to provide an answer for the first question we asked:
Will this company survive long enough for me to make money out of it?
Conclusion
There we have it. Five ratios you need to know. I’m only scratching the surface here of course, but even knowing these ratios is very valuable in understanding not only the likely answers to the three key questions but also in leading you to do extra due diligence on the ratios that seem off. Nothing can replace time, effort and attention when it comes to investing. Even your greatest failures will give you valuable insight into the mistakes in your process. Ultimately, that’s part of what we’re aiming for here, alongside amassing wealth: educating ourselves such that money becomes a tool at our command, rather than controlling our lives.
Until next time.