When deciding to put your money in the stock market, you first need to work on your investment plan. Your plan will depend on numerous factors, such as your personality, your trading capital, and your financial goals. This investment plan will dictate the way you enter and exit the market, as well as the way you manage your open positions. One of the key elements of an investment plan is therefore how you will analyze stocks. Technical analysis and fundamental analysis are the two main ways to analyze the markets.
While technical analysis relies on charts and technical indicators to analyze an asset’s price action, fundamental analysis relies on fundamental factors to determine the real value of an asset and compare it with its current market value, to see if it is under or over-valued. Many investors use fundamental analysis to pick undervalued stocks with great growth potential. For that, they need to look at key financial ratios and data to find out what a given company’s true worth and growth prospects are.
Let’s have a look at 5 of the most important financial ratios every stock investor should consider before investing in a company. Profit and loss (revenues, costs, expenses, etc.), balance sheets (assets, liabilities, outstanding shares, cash and accounts receivable, etc.), and cash flow statements (income, cash, depreciation, etc.) gather all the financial information needed.
Working Capital Ratio
Working capital ratio = current assets / current liabilities
The Working Capital Ratio expresses the ability of a company to finance short-term operations. With a value of around 1, the company analyzed has serious financial issues, as it means that it doesn’t have enough short-term assets to cover its short-term debts.
Price-to-sales ratio (PS/S)
Price-to-sales ratio = market capitalization or share price / total sales or revenues
The price-to-sales ratio is used to show how much investors place on the company compared to how much revenue the business generates. This ratio shows how market participants value every dollar of a company’s sales and helps compare companies of the same sector.
Debt ratio = total debt / total assets
This ratio shows how much debt a company is taking compared to its assets, which helps to determine debt risks. If the debt ratio is above 1, then it means that the company might be too heavily leveraged and could default on its debts. A debt ratio lower than 1 suggests that the company is funding its debt with its equity (not with its assets).
Operating profit margin (OPM)
Operating profit margin = operating profit (earning) / sales (revenues)
The OPM ratio shows to what extent a company is ‘operationally efficient’ and how it can create profit from its business after paying variable costs of production. The higher the ratio is, the more it shows that the company can turn sales into profits.
Price-to-Earnings ratio (P/E)
Price-to-Earnings ratio = stock price / earnings per share (net profit / average outstanding shares)
This ratio shows how much market participants are paying for each dollar of earnings and is a good measure with which to compare companies of the same sector. A high P/E ratio indicates that the stock might be overvalued by the market, or that its earnings are expected to grow quickly. On the other hand, a low P/E ratio could indicate that the stock is undervalued compared to the earnings per share.
These are just some of the most important ratios and financial data stock you can use to analyze a company and decide if you should invest, but there are many others you can use, like Return on Equity (ROE), Earnings per share (EPS), Price-Earnings (P/E) Ratio, and Dividend yield. You should also always consider the macro-economic situation, the business cycle, the quality of the management team, as well as the sector outlook before deciding to buy shares.