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:

  1. 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.

  2. 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.

  3. 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.)

  1. 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.

  2. 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.)

  3. 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.)

  4. 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.)

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!

Related Articles
  1. Investing Basics

    Calculating the Margin of Safety

    Buying below the margin of safety minimizes the risk to the investor.
  2. Entrepreneurship

    The Unintended Consequences of Outsourcing

    The outsourcing of labor overseas is a natural result of globalization of world markets and the drive for businesses to cut costs in order to maximize profits.
  3. Investing Basics

    10 Companies That Yuppies Love

    Learn about 10 companies loved by the modern Yuppie, including how this demographic's impressive buying power has boosted these companies' earnings.
  4. Investing Basics

    If You Had Invested Right After Amazon's IPO

    Find out how much you would have made if you had invested $1,000 during Amazon's IPO, including how the power of the stock split affects investment growth.
  5. Technical Indicators

    Key Financial Ratios to Analyze Airline Companies

    Examine some of the most important financial ratios and performance metrics investors use to evaluate companies in the airline industry.
  6. Technical Indicators

    Key Financial Ratios to Analyze Tech Companies

    Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
  7. Technical Indicators

    Key Financial Ratios to Analyze the Hospitality Industry

    Understand the hospitality industry and the types of companies that operate within it. Learn about key financial ratios used to analyze the industry.
  8. Entrepreneurship

    How Does ClassPass Work and Make Money?

    Find out how ClassPass makes money, how the company aims to help both businesses and consumers, and why it has been so successful.
  9. Stock Analysis

    Benefits of Regional Bank ETFs over Commercial Banks

    The SPDR S&P Regional Banking ETF offers a stable local alternative to broad-based multinational commercial banking sector funds.
  10. Professionals

    Holding Out for Capital Gains Could Be a Mistake

    Holding stocks for the sole purpose of avoiding short-term capital gains taxes may be a mistake, especially if all the signs say get out.
  1. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating ...
  3. Passive Income

    Earnings an individual derives from a rental property, limited ...
  4. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  5. Warren Buffett

    Known as "the Oracle of Omaha", Buffett is Chairman of Berkshire ...
  6. Investment Income Ratio

    The ratio of an insurance company’s net investment income to ...
  1. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  2. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  3. How can I find net margin by looking a company's financial statements?

    In finance and accounting, financial statements represent the fundamental means of analyzing a company's financial position, ... Read Full Answer >>
  4. How is the marginal cost of production used to find an optimum production level?

    The marginal cost of production can be tracked to show the optimal production level where per-unit production cost is lowest ... Read Full Answer >>
  5. What factors make it difficult to compare performance ratios between retail stocks?

    Companies that operate in the retail sector significantly differ in terms of their profitability and efficiency, making stock ... Read Full Answer >>
  6. How do investors interpret the same store sales ratio when analyzing food and beverage ...

    When an investor interprets the same-store sales ratio in analyzing food and beverage stocks, he looks at the monthly same-store ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!