While there is no such thing as a sure thing when investing in stocks, there are some "investing absolutes" that should be followed to make sense of financial statements and their impact on stocks. Financial statements are the building blocks upon which stock analysis should begin. However, it is often difficult to translate all the information provided into useful data. Here, we'll show you how to decipher a financial statement and then how to put that information to work to help you determine which stocks are likely to be strong performers for your portfolio.(To learn more, read What You Need To Know About Financial Statements.)
Margins - Is the Company a Strong Performer?
When looking at a company's financial statements, many investors start by taking a look at margins and the trends as a way to determine whether a company is moving in the right direction.
Investors like to see high margins and growing trends; declining trends can be worrisome. There are generally three basic margins that investors calculate:
Gross margin is the least complicated margin. It is calculated as the difference between revenues and cost of goods sold, and divided by the revenues. It tells investors how well the inputs used to make a product are generating a profit. However, this margin does not include all the costs associated with the product, such as selling and general administrative (SG&A) costs or research and development (R&D) costs, among others, so it provides an incomplete picture.
EBITDA margin is a little bit more inclusive. EBITDA margin includes all the costs associated with making and selling a product and excludes the non-cash costs such as depreciation and amortization. It also excludes the cost of taxes or interest payments on debt. Some investors like this measure because it provides the cash costs for operations but excludes costs unassociated with the actual good or service.
- Net margin includes all the expenses on the income statement. This shows how much of each dollar earned by the company is translated into profits. Companies that expand their net margins over time also tend to be strong performers, as this leads directly to higher levels of profitability.
Profitability Ratios - Is the Company Profitable?
The financial statements also provide a glance into the company's profitability. Profitability ratios provide a quick snapshot of a company's past profitability. Investors want these ratios to be high and to show an improving trend over time. Common profitability ratios include return on equity (ROE), which is the return shareholders receive for the equity they put into a company, return on investment (ROI), which is the return a company receives on invested capital and return on assets (ROA), which is the return a company receives on assets employed.
Stock Prices and Valuation - Will the Stock Be Profitable for You?
People often believe that the actual price of a stock is a representation of its value. In reality, this number means nothings on its own: a $100-per-share stock may be undervalued, while a $1-per-share stock may be overvalued. The actual dollar value by itself does not indicate whether a stock is expensive or inexpensive - it only indicates how many shares you can buy for a given dollar investment. (To learn more, read Don't Let Stock Prices Fool You.)
The actual stock price only matters as it relates to another data point. This relationship creates a multiple that investors use to determine whether a stock is trading at fair value or is under- or overvalued. There are many multiples that are used to determine this, but the most common are price to earnings (P/E), price-to-book (P/B), enterprise value to EBITDA (EV/EBITDA) and price to sales (P/S).
In many instances, multiples are not taken in isolation, but are compared to a peer in the same industry or to the company's historical range. In addition, multiples can be viewed in the context of the cycle - in other words, are we at the top or the bottom of the industry cycle? In many instances, a multiple may seem inexpensive when taken in isolation, but when compared to its peers, the historical range, or viewed in the context of a cycle, the multiple may actually show that the stock is overvalued. (For more on this, read Peer Comparison Uncovers Undervalued Stocks.)
P/E is the most common metric to compare between peers, and it relates the current price per share to the trailing earnings per share. In general, investors like to see a low P/E as it may indicate that the stock is undervalued. That said, there is a downfall to using P/E in that it can only be used if a company has positive earnings. In addition, P/E by itself is less useful with cyclical companies.
P/B, the price per share divided by the book value per share, indicates that a stocks is a good value when it is low. A stock is usually considered to be priced at fair value when the P/B is 1.0, however, if the P/B is less than 1 it could be a sign that something is fundamentally wrong with the company. This multiple is commonly used to value financial companies because earnings are a poor indicator of the future prospects of these companies. (For more insight, read Value By The Book.)
EV/EBITDA, which is calculated by dividing enterprise value by EBITDA, is widely used by many investors. EV/EBITDA, unlike other multiples, is easy to calculate and is not dependent on positive earnings or subject to as many accounting manipulations from non-cash items such as depreciation and amortization, which are excluded from the calculation of the multiple. Similar to the previously discussed multiples, investors like to see a low EV/EBITDA multiple, which indicates that the stock is undervalued. (For more insight on this metric, see Value Investing Using The Enterprise Multiple.)
- P/S is the price per share divided by the sales per share. It is often used with companies that have no or negative earnings, but do have sales. Early-stage companies generally fall into this category. Investors like to see a low multiple. (For more insight, see Use The Price-To-Sales Ratio To Value Stocks and Investment Valuation: Price/Sales Ratio.)
The Bottom Line
Investing in stocks has a language of its own, but understanding the most common metrics can help investors weed through all the noise to understand if a potential investment is likely to be profitable. So, before buying into a stock, be sure to break down the financial statements and run the numbers - after all, once you find a profitable stock, most of the hardest work is done. Then, you can sit back and "hopefully" let the profits roll in!