We're celebrating Financial Literacy month in numeric style. Follow our crash course on maximizing your portfolio and finances with The 10 Essential Money Lessons.
The worst thing you can do for your portfolio is to invest without digging into the numbers.
Seems like common sense. Sadly, some investors don't take the time to scrutinize those figures, much less understand the companies in which they invest.
In honor of financial literacy month, we're aiming to arm you with the tools to make smart money decisions. Today's topic is basic financial metrics and concepts. Spoiler alert: This isn't meant to be the definitive guide on financial metrics -- not even close. But the concepts that we highlight will help any investor examine companies with a critical eye.
Price-to-earnings ratio (P/E): One of the most basic valuation ratios, the P/E ratio does exactly what its name says: It compares the price of one share of stock to its earnings per share. In other words, how many years would it take before you'd recoup the cost of a share through its current earnings?
There are two main P/E ratios: trailing and forward. Trailing P/E compares today's share price to the company's earnings per share over the past four quarters, while forward P/E looks ahead to projected earnings over the next 12 months or fiscal year.
For example, Google
If you want to earn your gold star, try calculating the price-to-free cash flow ratio. Free cash flow is tougher for companies to manipulate than earnings.
Consistent revenue and earnings growth: We like to see companies steadily increase their revenues and earnings, and so should you. This might require a bit more number-hunting if you're looking over several years, but it helps to determine whether your investments have a track record of growth.
Let's look at Cisco's
|
Growth over prior year |
FY 2004 |
FY 2005 |
FY 2006 |
FY 2007 |
FY 2008 |
|---|---|---|---|---|---|
|
Revenue growth |
16.8% |
12.5% |
14.9% |
22.6% |
13.2% |
|
Earnings growth |
26.1% |
39.1% |
2.5% |
31.5% |
11.7% |
Based on this, investors would want to dig into the reasons behind the yearly fluctuations, and any disparities between revenue growth and earnings growth. For example, why was there a growth dropoff between 2007 and 2008? And why did earnings only grow 2.5% in 2006, while revenue grew 14.9%?
Margins: Gross, operating, and net margins help us see how efficient a company is run. These margins are defined in our Foolish Fundamentals on margins:
- Gross margin equals gross profit divided by sales. It indicates how well management is using labor and materials to support the business.
- Operating margin equals operating income divided by sales. This is one way to show how well management is running the business.
- Net margin equals net income divided by sales. This is the bottom line, the amount of money left after all expenses are paid.
Ideally, margins should be growing steadily, but that's not always the case. If there are any unusual movements, take the time to understand why.
Enterprise value (EV): Enterprise value is essentially the amount that you (or a really, really rich person) would need to purchase a company completely. It goes beyond market capitalization, adding in total debt and subtracting cash. Don't just take this number from a website; take the time to figure out how much debt and cash the company has on hand. That's useful knowledge for an investor. If the enterprise value is much higher than the market cap, the company's most likely carrying loads of debt, and vice versa.
|
Company |
Market Cap (in billions) |
Enterprise Value (in billions) |
|---|---|---|
|
Apple |
111.8 |
85.4 |
|
Boeing |
28.3 |
33.5 |
|
General Electric |
125.3 |
603.3 |
Source: Yahoo! Finance.
Companies like Boeing carry a fair amount of debt (in GE's case, a ton of debt), while Apple has a healthy amount of cash in the bank. Acceptable debt loads vary by industry, but careful investors must evaluate whether their companies are properly weighing debt's favorable effect on return on equity (see below) against the increased risk brought by mandatory interest payments.
Return on equity (ROE): ROE is calculated by dividing a year's worth of earnings by a company's shareholder equity. In other words, it measures just how profitable a company is for its shareholders. As our Million Dollar Portfolio book explains, "A good return on equity is important because it indicates a company that can make a lot of money without a lot of continued investment. This metric generally indicates a company with a strong brand or dominance in its market; and it should mean that the company will hold up well if economic times get tough."
Let's look at the ROEs of several companies in the consumer goods space.
|
Company |
Return on Equity (Trailing 12 Months) |
|---|---|
|
Church & Dwight |
16.2% |
|
Kimberly Clark |
35.5% |
|
Procter & Gamble |
18.5% |
Source: Capital IQ, a division of Standard & Poor's.
Beyond the metrics
Got those terms down cold? Great! Here are a few additional tips:
- Never evaluate a company using a single financial metric. No, seriously, we mean it!
- Compare these metrics against those of a company's competitors for a better idea of the overall sector.
- And while all these metrics are important, how you use them is equally important.
Above all, never go just by the numbers. Make sure you understand the company's business model and how it generates revenue. If you can't explain it, chances are you shouldn't be investing in it.
