Trading and investing can involve a lot of comparing. We do this to not only get a feel for our investments but to also value new ones.
One of the easiest ways to compare anything is via ratios.
Three of the more pertinent and popular ratio families that traders use to gauge the value or viability of a stock are liquidity, profitability, and valuation ratios. However, these three categories encompass dozens of granular variations, all pulling from separate company statistics to arrive at their given quotient.
Let’s pick apart some of the individual ratios covered by these larger concepts with the help of a handful of widgets from the stock research platform FinanceBoards.
Liquidity Ratios
First up, the liquidity ratios widget, which boasts a full dozen individual ratios. At their core, each serves as a gauge on the net assets a company does (or doesn’t) have over its total debt liabilities. Let’s look at the widget’s read on Apple Inc. AAPL.
The “current ratio,” as stated above, just divides Apple’s total assets to its total long- and short-term debt obligations. While this shows Apple has its head above water in terms of its macro balance sheet, for investors, the utility of such broad indicator is limited. The FinanceBoards’ widget does offer traders wider insight into prevailing industry, sector and market trends with regard to liquidity.
Many investors instead like to look at more telling indicators of short term liquidity like quick ratio, a company’s liquid assets over its short-term debt, or its cash ratio, solely a company’s cash and marketable securities over its short-term debt. These ratios can give an indication of how, why and where a company is spending or accruing capital.
Other, more involved statistics, like cash conversion cycle (measuring the amount of days it takes to convert cash to inventory to sales and back to cash) or the arcane Altman Z score (a predictor of the probability a company will go belly-up in the next 2 years whose equation is far too involved to get into here) similarly focus on specific metrics related to a company’s credit and debt assets.
Profitability Ratios
In a similar vein to liquidity ratios, profitability ratios reveal a company’s key cash flow statistics, although on a much more transactional level. Profitability ratios focus on a company’s ability to create revenue compared to the cost of doing business.
Again, the FinanceBoards widget lists an intimidating 17 sub-statistics to choose from, although some of these are split between looking at the company’s trailing twelve months (ttm) and it’s most recent quarter (mrq).
Of the more common criteria surveyed by traders are gross profit margin, earnings before interest, tax, depreciation, and amortization (EBITDA) margin, and free cash flow margin.
The first two of these are measures of a company’s ability to earn a profit. The former, gross profit margin looking only at profits made from sales minus the cost of the goods up until the point of sale. The latter, EBITDA margin, based solely on generating revenue, excluding things like expenses reflected through financial or accounting decisions and taxes.
Free cash flow margin, on the other hand, is a measure of per dollar efficiency provided by companies on the cash flow and income statements. In effect, it shows a company’s yearly performance based on how much profit it makes from every dollar it spends.
Valuation Ratios
Finally, one of the main statistics fundamental traders evaluate when considering a position is the discount or premium they are receiving from a purchase. To arrive at that determination, they look at valuation ratios, typically the P/E ratio a company’s per-share price over the earnings value of its outstanding shares.
Of, course, there are plenty of other metrics traders use to find value. We’ll take a look at a few of the standouts that help traders key-in on unique equity texture, again, through the lens of Apple.
Immediately after Apple’s P/E ratio, you’ll see two similar measures of value that take a more growth-oriented look at value. The price to sales ratio compares a company's share price to its top-line sales growth and price-to-book which, very pragmatically, examines per share price over the business’ previous quarterly per-share net asset value. Price to tangible book value works similarly but excludes intangible assets like intellectual property.
Jumping down, the two price to cash flow metrics simply look at price compared to liquidity, with free cash flow excluding overhead operating expenses. This is useful to get a picture of how a company strikes a balance between liquidity and growth investments. If the ratios comparatively low, it means cash is tight, a high ratio shows there’s more capital on hand than the company knows what to do with.
This crash course is only a soupcon of the ratios you should know about when doing research. Those looking to learn more would do well to play around with some of the other ratios and widgets offered on FinanceBoards.
FinanceBoards is a sponsored partner with Benzinga. This article was written in conjunction with FinanceBoards, and may have been subject to their approval.
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