Investment Ratios and Metrics – Gaining Insight From the Numbers

Overview – Using Investment Ratios and Metrics

It’s no secret that analyzing prospective companies to invest in, as well as the constant re-assessment of current holdings, is a very quantitative activity. There’s always an abundance of numerical data for investors to analyze.

Companies flood investors with a seemingly infinite amount of numerical data, but what distinguishes the analytical skills of different investors is how they extract meaningful insight from what usually looks like a disorganized mess of numbers.

In this article, we will go over the importance of using relevant investment ratios and metrics when conducting analysis, go over some commonly used ones, and how to properly use them.

Looking at Raw Financial Data is Not Enough

Below are two hypothetical companies – “Company ABC” and “Company XYZ”. Imagine that each of these companies reported the following financial data for the past five years:

Company ABC Select Financial Data

Company XYZ Select Financial Data

Let’s also assume that both companies are approximately the same size (in terms of market capitalization – the value of a company when the share price is multiplied by the number of shares outstanding), both companies operate in the same industry and provide the same services (i.e. they are competitors), and both operate in Canada.

For this example, we will not be considering any qualitative factors, such as management competence, reputation, customer relations, and future business prospects.

Assuming every aspect of both companies are approximately the same, one of the only remaining options to determine which company is a more attractive investment is to look at the select financial data above.

When analyzing just raw data, it’s immediately clear that very limited insight can be gleaned from it.

It’s true that Company ABC shows steadily increasing revenue, but Company XYZ’s revenue, though inconsistent, is regularly higher than Company ABC’s.

Beyond recognizing some trends in the data, not much can be said about a company just by looking at their numbers, no matter how long you study them.

To get more insight from the numbers, we’ll need a different approach: this is where investment ratios and metrics come into play.

The Importance of Using Investment Ratios and Metrics

Meaning can only be gleaned from raw financial data when numbers are compared with other numbers or with some established benchmark – one way to accomplish this is by using ratios and metrics.

Once numbers are analyzed using investment ratios and metrics, a lot more insight can be gained from reading through a company’s financials because the investor begins to see how financial data relates to other financial data across the three financial statements.

Relationships between seemingly disparate items – net income, equity, total assets, earnings per share, stock price – start to form. Once these relationships become clear, this is when an investor starts to truly grasp the investment merit of a prospect.

Making use of investment ratios and metrics in investment analysis is critical because it establishes context for the data. Without proper context, financial data is worth very little, no matter how much of it you have.

Imagine a company reports a yearly revenue of $1 million – some investors may find this number impressive and think nothing more of it.

However, an intelligent investor knows that reporting revenue alone is utterly meaningless because it is not presented as part of a more complete financial picture, that is, there’s no context.

If the company reports expenses of $100,000, their net income would be $900,000 – an encouraging sign of excellent financial health (until this net income is compared to the industry average, and further context is established).

Conversely, if the company reports $1.5 million in expenses, they are now $500,000 in the red – that $1 million in revenue is now much less impressive. Financial data is only as impressive as what it’s compared to.

Without this knowledge of how revenue compared to expenses then you’d have no way of telling whether this $1 million was impressive or not. It’s very rare for financial data to be isolated, that is, almost all financial data is related to another set of data in some way.

If you have read through an annual report before, chances are the first few pages are filled with vibrant pictures, colourful graphs, lots of buzzwords, and carefully selected financial data – all in an attempt to create a strong impression, and in some cases lull the casual reader into thinking everything is fine.

Intelligent investors know to look past the dazzling graphs and cherry-picked values and instead will eventually head to the financial statements to start understanding what’s really going on with the numbers.

Management can choose to present carefully picked numbers however they want, but the intelligent investor will recognize the façade and immediately apply the appropriate ratios and metrics to understand what’s going on.

So, what investment ratios and metrics should investors know?

Some Common Investment Ratios/Metrics

This article will not list every ratio under the sun; there are dozens (if not hundreds) of ratios in existence, many of which investors come up with on their own (to extract meaning from specific bits of financial data of their own choosing).

Although there are countless ratios in existence, there are some that investors will come across time and time again. Let’s go over what those are.

Price-to-Earnings Ratio (P/E)

Price-to-Earnings (P/E) Ratio = Stock Price/Earnings per Share = Market Capitalization/Net Income

Arguably the most reported and used investment ratio, the P/E ratio is a measure of how much an investor is willing to pay for every dollar of a company’s earnings.

For example, a P/E ratio of 20 means an investor is willing to pay $20 for every dollar of a company’s earnings. A higher P/E ratio usually means investors expect a company to have significant growth prospects (investors expect earnings to catch up to the disproportionately higher stock price) and is sometimes a sign that a company may be overpriced.

A lower P/E ratio usually suggests a company is priced more reasonably, but that its growth prospects are limited. Low P/E ratios are usually common for very stable businesses like utilities, or very well-established businesses (very large and well-established businesses are known as “blue chips”).

Recall that earnings (net income) are reported over a company’s fiscal year. A company’s net earnings for a given fiscal year, divided by the total number of outstanding shares at the time of reporting gives the trailing earnings per share figure.

When earnings for a company are predicted for the coming fiscal year, using that earnings figure produces the forward earnings per share.

When calculating the P/E ratio, when trailing earnings per share is used you get the trailing P/E ratio. When using forward earnings per share you get the forward P/E ratio.

Price-to-Book Ratio (P/B)

Price-to-Book (P/B) Ratio = Stock Price/Book Value per Share

Book Value can be thought of as what a company would be worth “on paper”: it can be calculated by subtracting total liabilities from total assets, assuming there are no preferred shares that have been issued.

If preferred shares have been issued, then total liabilities and the value of preferred shares must be subtracted from total assets.

Therefore, book value per share would be common stockholders’ equity divided by the average number of outstanding common shares, or in other words, the total amount of money put into a business on a per-share basis.

Book Value per Share = (Total Assets – Total Liabilities – Preferred Stock)/Outstanding Shares

P/B is a measure of a company’s market value relative to how much they are worth based on their current assets less liabilities and preferred shares.

A low P/B (or a P/B less than 1) may indicate that a company is undervalued relative to its “paper” worth, but a high P/B does not necessarily make a company overvalued or less attractive for investment.

There’s also a variant of the P/B ratio known as Price-to-Tangible Book Value (PTBV).

Tangible book value omits the inclusion of intangible assets (goodwill, intellectual property, software, brand recognition) from the book value calculation. The resulting book value consists of only tangible (physical) assets.

Note that PTBV isn’t necessarily a “better” way to calculate book value. Some companies, like software companies, have many assets categorized as intangible, and the use of PTBV would severely underestimate the book value of companies that have a significant portion of their assets categorized as intangible.

Return on Assets (ROA)

Return on Assets = Net Income/Total Assets * 100%

Return on Assets is a measure of how effectively a company uses their assets to generate income.

For example, imagine a printing company that owns several printing presses. If the company owns $100,000 worth of printing presses and generates $40,000 in net income, they have a ROA of 40%.

A high ROA generally means a company is effectively using its assets to generate income – this is desirable since the purpose of purchasing assets in the first place is to help a business earn money.

A low ROA may indicate that management is making poor decisions when deciding how to allocate their resources or is spending too much money on assets they don’t really need or aren’t fully utilizing.

Return on Equity (ROE)

Return on Equity (ROE) = Net Income/Total Equity * 100%

Similar to Return on Assets, Return on Equity is a measure of how effectively a business uses the money that investors have contributed to a business (equity), as well as any retained earnings, to generate income.

A high ROE is generally indicative of a business that efficiently uses shareholder money and retained earnings to generate income. A low ROE isn’t automatically a red flag, but it isn’t encouraging either.

In the 1920s, the American company DuPont introduced a formula that breaks down ROE into three distinct elements. Aptly named the “DuPont Formula”, the three elements of ROE are as follows:

Return on Equity (ROE) = (Net Income/Sales) * (Sales/Total Assets) * (Total Assets/Equity) * 100%

From a mathematical perspective, this equation is correct, since the “Sales” and “Total Assets” terms cancel, leaving only Net Income/Equity.

Put into words, the above equation means that return on equity is a product of Net Profit Margin (Net Income/Sales), Asset Turnover (Sales/Total Assets), and Leverage (Total Assets/Equity).

Breaking down ROE into three parts helps companies understand changes in ROE over time, and which factors play a role in affecting the ROE.

For example, a company may have poor profit margins but still have an increase in ROE simply because they took on more debt (an increase in leverage).

There’s also a variant of ROE known as Return on Common Equity (ROCE), which takes on the following form:

Return on Common Equity (ROCE) = Net Income/Common Shareholder Equity * 100%

ROCE measures how effectively funds contributed by common shareholders are being used to earn money. Generally speaking, the higher the ROCE, the better.

Free Cash Flow (FCF)

Free Cash Flow = Cash from Operating Activities – Capital Expenditures

Though not a ratio, free cash flow is a widely used metric that investors use to gauge how well a company generates cash.

Remember, items on the income statement are not necessarily all cash. A company can boast about impressive net income but still suffer from a lack of cash.

Free cash flow is a closely watched metric because this is the cash available for companies to repay creditors, pay dividends, and pay interest, without having to resort to using retained earnings or taking on more debt.

Capital Expenditures is an item that is reported in a company’s statement of cash flow, under Investing Activities. However, not all companies report this value. Fortunately, capital expenditures can be calculated using the following formula:

Capital Expenditures = [Change in Property, Plant & Equipment (PP&E)] + Depreciation & Amortization

“Chane in Property, Plant & Equipment (PP&E)” means the difference in PP&E between the year of interest (the year you want to know the free cash flow for) and the preceding year.

The value of a company’s PP&E can be found on their balance sheet, listed under assets. For example, say that a company reports a PP&E value of $100,000 in 2019 and a value of $80,000 in 2018. The change in PP&E would therefore be $20,000.

Note that change in PP&E can sometimes be negative, which means the company sold PP&E assets instead of purchasing more.

“Depreciation & Amortization” can be found in two statements. It can be found in the income statement listed as an expense, or in the cash flow statement under cash from operating activities (specifically under the sub-section “adjustments made to net income”).

Sometimes depreciation and amortization are reported separately, in which case you will just need to add the two values.

Not All Investment Ratios Will Apply

It is very important to keep in mind that although there are countless investment ratios that can be used, not all of them will be appropriate to use in all circumstances.

Knowing which ratios to use when analyzing a company depends entirely on the nature of the company’s business.

Take Price-to-Tangible Book Value (PTBV), for instance. This ratio may be useful for analyzing companies that own a lot of tangible assets, such as Enbridge (pipelines and other physical assets) and Costco (their warehouses).

PTBV may be less effective for technology companies, such as Microsoft or NVIDIA, which own lots of intangible assets in the form of intellectual property and patents; using PTBV on these companies would result in a skewed analysis.

Real Estate Investment Trusts (REITs) operate very differently from a business that sells products or provides services, so ratios such as P/E, P/B, and Earnings-per-share are usually considered inappropriate when analyzing REITs.

Before using investment ratios, it would be wise to find out which ones investors are using to analyze a particular company and different companies across the same industry.

Knowing which investment ratios will provide the most insight and applying the same ones to a company’s competitors will help make analysis much more effective since it will be done on an apples-to-apples basis.

Determining Whether an Investment Ratio is “Good” or “Poor”

Notice in the preceding section “Some Common Investment Ratios”, no absolutes were given when interpreting the numerical values of the ratios.

A higher P/E ratio is generally a sign of expected growth, a P/B less than 1 may indicate a company is undervalued, a high ROA and ROE is generally a good sign: notice that generalizations were always being used. This was done deliberately.

Recall that the purpose of using investment ratios is to compare a company’s financial data with respect to other financial data, and that meaning can only be extracted when comparisons are made.

The same principle applies to ratios: investment ratios are only as good as what they are compared to.

Industries generally have average P/E, P/B, and other average ratio values. Comparing a company’s ratios to industry averages, against a company’s historical data (is there a trend in previous ratios?), and against its peers will determine whether specific ratio values are causes of concern. 

For example, a P/E ratio of 15 for a utility company may not sound so bad, until you learn that the industry average is 8. An ROE of 10% doesn’t sound too bad until you realize the average ROE of the company for the past 10 years was 20%.

Performance is always relative in investing, therefore when assessing whether a certain ratio is acceptable or not, one of the first things an investor should ask is “what can I compare this against?”. Without some sort of benchmark, you’ll never get an accurate measure of performance.

Wrapping Up

Staring at a company’s raw financial data will do very little to advance your analysis. Only when numbers are compared to one another by using ratios will meaning start to be gleaned from seemingly disparate data points.

Myriad ratios exist for investors to use, but only a handful of ratios will apply to a specific company and its industry: knowing what those ratios are and why they are being used is what intelligent investors do.

Judiciously selecting relevant investment ratios and knowing which values to compare ratios against are critical to ensuring an investor’s analysis is as effective as possible.