How to Evaluate a Corporation Using Stock Ratios
Return on equity (ROE), quick ratio, debt covering ratio, debt-to-equity ratio and price-to-book ratio (PBR) are all ratios that can be calculated to provide clues about a company’s finances.
Evaluate management with the return on equity
ROE measures the return on your investment in the company by showing how well the company invested its investors’ money and the company’s accumulated profits. To calculate ROE, divide net annual profit by total equity:
ROE = Net Annual Profit / Average Annual Shareholder Equity
To determine net annual profit, total the company’s net profits presented in each of its four most recent quarterly income statements. To determine equity, average the shareholder equity for those same four quarters; you can find that info on the balance sheets for the most recent quarters.
After you discover the company’s ROE, compare it to others in the same sector. The company with the higher ROE is the more profitable one; try to find companies with an ROE of more than 10 percent. A terrible ROE (say, 0 percent) means the company is mismanaged.
When valuing a stock, ask yourself whether the ROE beat the rate of return the company could have earned just by putting the money into Treasury bonds. Look for companies that post an ROE greater than 10. After you’ve found that, go to the Yahoo! Finance Industry Browser to see whether the company’s ROE exceeds others in its sector and if so, how many. You want to buy companies with high ROEs that have seen an upward trend over the past five years.
Sneaking a peek at the quick ratio
One of the best indicators of a company’s ability to pay dividends moving forward is the quick ratio, which looks to see whether a company has enough liquid assets to cover dividends. Because inventories are the least liquid portion of current assets, the quick ratio removes them from the equation. To derive the quick ratio, subtract inventories from current assets; this removal leaves you with the firm’s most liquid assets. Then divide the result by current liabilities.
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
If you want to get extremely conservative, move beyond the quick ratio and just look at the cash on hand. Pure cash provides the best measure of whether a dividend can be paid because the current assets in the quick ratio may include a lot of accounts receivables from customers who can’t pay or aren’t required to pay their bills in the time frame that dividends are scheduled to be paid.
Covering the debt covering ratio
Debt Covering Ratio = Operating Income / Current Liabilities
The debt covering ratio should equal at least 2. A debt covering ratio below that means the company may not be generating enough to pay both its interest payments and dividends.
Valuing the debt-to-equity ratio
An additional ratio to check for the stability of the company in general and the dividend in particular is the debt-to-equity ratio, which shows how much debt a company has compared to its equity. A high debt-to-equity ratio shows that the company relies on debt rather than equity to finance its operations and presents a clear warning sign. The equation for the debt-to-equity ratio is:
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
You can find these numbers on a company’s balance sheet.
Working with price-to-book ratio
Book value = Tangible Assets – Liabilities
Price-to-Book Ratio (PBR) = Market Value / Book Value
Book value can be misleading because the assets category on the balance sheet reflects the company’s cost to acquire an asset, not necessarily the asset’s current market value. The greater percentage of total assets made up by current assets, the more accurate book value becomes.