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Fundamental Investing: Things to Look at When You Invest (Part 2 — Ch. 1)
What are the financial ratios needed for you to select good stocks?
Before this, we have spoken about the first step for you to select your stocks, whereby you’ll have to get a general overview of the business. There are generally three main steps for you to do it (of course, this varies according to your preference, but this is how we generally do it).
If you haven’t read that article yet, you can check it out below:
The first step, as discussed before, is to look at the business overview to get a first glance at how the business is doing on the surface. If they pass the test, move to the next step, which is what we’ll talk about now: applying financial ratio analysis on these stocks to see if it coincides with the good face value you’ve analyzed before. If this step is passed, move on to the last step which is to look at Discounted Cash Flow (DCF) to see if the price that you’ll buy it at is worth it or not.
Just in case you don’t know, we’ve detailed out on a lot of financial ratios that you may want to look into in order for you to look at a company’s financial performance. You can look at the chart below to get an overview of it. The question is, should use all of it when you want to start investing?
The answer is… if you have the time — why not? But if you don’t, we’d only suggest you look at only a few of these ratios just to get the insights necessary in each relevant aspect of the company. Although mind you, these are not necessarily the case for everyone. Different people have different strategies, aim, goal, and risk tolerance — but this serves as a general guideline for those who are just getting started.
So, what ratio should you look at, and what aspects should you be concerned about?
Before we start…
Before we start, our advice is to look at the data from at least 5 years back to get a general sense of how a company is doing. Generally, the more the better, but it will depend on your targeted investment period as well. In this article, however, we only look at 3-year data to make it easier (and to save ourselves some time).
Another thing, you’ll have to also look at the company’s competitors’ performance in these indicators to get the real picture of how well a company is doing. For example, Company ABC’s revenue is down by 10% in a year — that’s bad, isn’t it? Now, what if in that year, the industry that Company ABC is in, is currently going through some rough patches and the closest competitor to ABC is down by 30%? Company ABC won’t look too bad now, would it?
The whole purpose of investing is so that you can grow your money by planting it in a company that will grow. The most apparent way of looking into a company is by looking at how the revenue is growing.
In doing this, you should look at the company’s annual net income growth, which is the money they make after deducting expenses, etc.
After that, you’ll have to see if the growth is in line with its gross profit growth. This is to see if the company’s expenditure actually eats up into the profit they make. Say, if a company’s net income grew by 10%, but its gross profit grew by 30%, you can tell that a lot of its money is being used to pay for things, that’s why despite the larger growth in gross profit, its net profit isn’t growing as big.
Is that a bad sign tho? We’ll call it a flag (not even a red flag) which requires you to look into why this is happening. Sometimes the company spends more in a particular year to expand its equipment, plants, market, etc., or it could also be that the company just isn’t doing well.
The easiest way to do this is to calculate the % of the change in its net income compared to the % of the change in its gross income. After doing that, you can also look if the growth is in line with its PAT Margin.
Below, we have Apple’s financial statement from its FY2022 financial report. If you look at the table below, the “Total net sales” is its gross profit, while the “net profit” is its net profit.
From this, we’d advise you to organize it in a table for an easier view (mind you our calculation may not be accurate as we go with the rough estimates).
We can now see that Apple’s gross income growth is growing well over the years (apart from the sudden jump in 2021), and this coincides well with the pattern in its net income growth as well as its PAT margin growth pattern.
The PAT margin will also tell you the actual profit the company is making, so you can tell that Apple’s actual profitability is declining, and this would generally raise concerns. From here onwards, you’ll have to compare Apple’s performance with its competitors such as Samsung or Microsoft. Sometimes it can be the industry itself that is problematic.
It can also be due to the purchase of new machines, equipment, or plants; so, from here, your conclusion should be: Apple’s earning growth is declining, because… (it can be that Apple is performing badly, or it is investing more in new things, or the industry itself is slowing down, or any other reason you find as you go through).
Good cash flow
Another thing that you’d want to look at is the cash flow of the company. The general rule is that positive cash flow from operations indicate that the company is doing good. However, if you see that the company’s cash flow from operations is negative, you’ll have to ask yourself the same question as before — is it an industrial thing, due to justifiable reasons, or because the company is doing badly?
Why? Because cash generated from operations here refers to the amount of money, they make from their core operations. If you want to see how well a burger chain is doing, the cash generated from operations here details down how much they made from selling burgers (and things related to it).
Apple, for example, has been showing constant growth in its cash flow from operations. This is generally a good sign for investors.
So, generally, a positive number in cash generated from operations would be a good sign, but of course, you’ll have to look into other indicators as well to confirm your hypothesis.
Much like the ones we have mentioned before, many investors would look into a company’s financial performance, and the way this is usually done is by looking into its earnings per share (EPS). EPS is calculated using the formula:
EPS = (Net Income — Preferred Dividends) / Average Number of Outstanding Shares
Do you have to calculate it yourself? You can if you have the time, but this data is usually available online at the convenience of a single search. Why EPS is often looked at because it tells investors how much the company makes per its common shares. If you invest in the company’s common shares, how much would that bring to your table?
Do note, however, it doesn’t literally put money on YOUR table, but it tells you how well the share is growing. This is particularly important for people who invest in dividend stocks because the more the company’s EPS grows, it’s more likely that the dividend you’re going to get will grow along with it.
Let’s take a look at Apple’s annual EPS, just for the sake of it, and we found this data online, just in case you’re wondering.
As you can see, Apple’s EPS has been growing steadily over the years. Now we’ll look into its dividend payout:
As we can (barely) see, Apple’s dividend payout mostly increases alongside its EPS. What’s up with the huge drop, tho? Apple actually split its shares with a 4:1 split on July 2020, so, whoever held Apple’s shares prior to that will have their number of Apple’s shares multiplied four times.
Say, if you held Apple’s shares prior to the execution of the split and you don’t sell them, this is how your graph would roughly look like.
So, where are we going with this? What you can jot down in your notebook after looking at the company’s EPS is how stable is the company’s finances (roughly), and if you’re into dividends, it may tell you about the possibility of you earning more from dividends in the future.
This is only the first chapter of this series, but by now you’ll have a few indicators to work with. In this chapter, you’ll figure out on how to look at a company’s revenue growth, its performance in terms of cash flow, and how well its financial performance is by looking at its EPS. Here are a few things that you’ll need to take note of:
- Use data from a few years (we’d suggest a minimum of 5).
- Corroborate your hypothesis in one indicator by looking at other indicators.
- Get the full picture of why the company is performing in such a way by looking at the indicators of its competitors within the same industry.
The key takeaways/market update is a series by AxeHedge, which serves as an initiative to bring compact and informative In/Visible Talks recaps/takeaways on leading brands and investment events happening around the globe.
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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.