There are many things people say to do before investing, such as pay off high interest debt, have an emergency fund, make sure you can afford to invest. However as much as its about ensuring you are in a good financial position to invest, it’s also about knowing what you are investing into. Whether it’s the latest trends in the industry, how laws may affect your investment or a company’s finance, having a sound knowledge of where you’re putting your money is key.
Today we are focusing on understanding the financial performance of where you choose to invest your money. Picture this, you want to invest into a company but no nothing about how much profit they make, or how much other investors are willing to pay - would you do it? Probably not, which is why we are sharing 6 simple calculations to delve into the financials of a company.
Operating Profit Margin
What: How much profit a company makes on a dollar of sales after paying for variable costs. It focuses on how well the operations contribute to the profitability of a company.
How to work out: Operating profit/net sales. It is usually expressed as a percentage.
Interpretation: The higher the better. Compare the operating profit margins with similar competitors and understand which companies are more profitable.
Price to Earnings
What: The amount an investor is willing to pay in order to receive one dollar of a company's earnings. It can be used to avoid overpaying for stocks and standardises the different prices and earnings levels of companies.
How to work out: Stock Price Per Share / Earnings Per Share
Interpretation: A high price to earnings ratio could mean that a stock's price is possibly overvalued because the price is high in comparison to the earnings of a company. A lower price to earnings ratio may indicate that the stock price is undervalued and low relative to earnings.
Price to Book Value
What: This indicates whether or not a company's asset value is comparable to the market price of its shares. The book value of a company is the assets minus its liabilities .
How to work out: Price per share / the book value per share.
Interpretation: Any value under 1 is considered as a good price to book value. Value investors often consider investing in stocks with a price to book value under 3.0.
Debt to Equity
What: The degree to which a company is financing its operations through debt.
How to work out: Total liabilities (debts) by its shareholder equity (what owners can claim after subtracting total liabilities from total assets)
Interpretation: The optimal debt-to-equity ratio varies on the industry e.g. think of those industries that require a lot of expensive machinery and have to use credit to purchase it, but the generally it should not be above 2.0.
Return on Equity
What: Measures the profitability of a business in relation to the equity it holds, when comparing companies of the same industry.
How to work out: Net income (after preferred stock dividends but before common stock dividends) / total equity (excluding preferred shares). It is usually written as a percentage.
Interpretation: A good Return of Equity is around 15–20%
What: How much a company pays out in dividends each year relative to its share price
How to work out: Dividend per share / market price per share * 100.
Interpretation: Higher yielding dividend (i.e. around 10%) stocks provide more income, but they often come with greater risk. Lower yielding dividend stocks equal less income, but are more stable.