How to Become an Investment Ninja (Part 3)
Wow! You must really like reading everything I have to say. I mean, I'm flattered, but I don't want you to get the wrong idea. I mean, I have other readers. I'm not ready for that sort of commitment. Don't be weird.
If you're ok with that, Let's go over Ratios!
As I said when we started, my goal for this series of articles is for you to be able to comb through all of the information that appears once you search for a company on the Pitly App.
Now you know how to read a stock quote and look at the share price chart over time as well as how to read the Income Statement and the Balance Sheet.
Ratio's help you tie it all together and actually determine if the company is a good investment.
The Income Statement tells us how much money the company is making (or losing). The Balance Sheet tells us how much assets and debt (a.k.a. Liabilities) the company has. Ratios are shortcuts to see a company’s financial health quickly.
Remember that some of the questions you should answer when looking at a company to invest in are:
How profitable is the business?
Is the company growing?
How is the company’s financial health? (assets / debt)
To answer these questions, we have to be able to understand the numbers behind the company. You know how to read financial statements, now lets find out what it all means.
The Ratios in the Pitly App are split in four categories: Profitability Ratios, Valuation Ratios, Growth Ratios, and Financial Strength. Let’s talk about the main ones in each category.
These ratios tell you how much money the company is actually keeping when they sell a product.
Gross Profit Margin is calculated as Gross Profit divided by Revenue. Gross Profit is Revenue minus the Cost of Goods Sold (COGS).
I don't remember what COGS are! Ahh, glad you asked. Those are the costs directly associated with making the company’s products. In Tesla’s case, COGS would include the metal used to make the body of the car, the rubber for the tires, and the battery components.
Tesla’s Gross Profit margin is 22.85%, which means that for every dollar of revenue they generate, they keep almost 23 cents.
Operating Margin accounts for the next level of expenses. It is Operating Profit divided by Revenue. Operating Profit is Gross Profit minus all other expenses the company incurs. These include rent for factories and other property, salaries for sales people, marketing costs, research and development of new technology and products.
Tesla’s Operating Margin is -9.53%, so they are losing 9.53 cents for every dollar of revenue they generate.
You may be asking yourself… how the f&%k is this company worth $61 billion dollars if they are losing money?!?!
Don’t worry, we’ll get to that when we cover valuation ratios below.
Net Income Margin is Net Income divided by Revenue. Net income is Operating Profit minus expenses that are not from operations such as interest and taxes.
Now that we’ve covered margins, let’s jump ahead to EPS (Earnings Per Share). This is Net Income divided by the total number of shares outstanding. This doesn’t mean that every one of Tesla’s shares are losing -$4.68 cents. That is just an easy way to gauge how a company is doing on a per share basis since prices are also per share. It’s more of an apples to apples comparison. Even if this was a positive number, you couldn’t just claim that the company pay you that money. They have to declare a dividend for that. Nice try tho!
ROE (Return on Equity), ROA (Return on Assets) and ROI (Return on Investment) are ratios that measure how efficiently a company uses its resources. Check out Pitly Lessons for a more in-depth explanation.
The P/E Ratio or Price to Earnings Ratio is calculated as Price Per Share divided by Earnings per share for the last twelve months. It tells us the premium the market is paying for earnings. In Tesla’s case the P/E Ratio is negative so it doesn’t mean anything. Price to sales and revenue growth more accurately explains Tesla's value. I promise, that will make sense later in this post.
For a more meaningful example of a P/E ratio, let’s look at Netflix. Its P/E Ratio is 323.75 and its EPS is only $0.44.
Investors are willing to pay $323 for every dollar in current earnings. The reason for this is that investors are counting on earnings being higher in the future as the company continues to grow. That seems expensive. We could argue whether that is too high a price to pay or not.
Price to Sales is similar to the P/E ratio only that price is divided by Revenue per share (a.k.a. sales) for the last 12 months. In this case, Tesla investors are willing to pay 5.77 times the current Revenue which indicates they expect sales to be higher in the future.
Neither the P/E ratio nor Price to Sales Ratio tell you much by themselves. You should compare these figures to the industry average or similar companies to see how “expensive” this stock is compared to its peers.
Revenue growth shows how much the company’s revenue has grown from last year. Tesla’s revenue in 2016 grew 73% from the year before. Generally, the higher the historical revenue (along with positive future expectations), the higher the P/E Ratio and Price to Sales Ratio.
As an exercise, you can look at the industry averages for different industries, you’ll see that tech companies (i.e. Google, Facebook) usually have higher revenue growth figures and P/E ratios than consumer goods companies (i.e. Procter & Gamble).
This doesn’t mean you should buy Tech companies over consumer goods companies! There’s a place on your portfolio for both. We will discuss the benefits of diversification in another post (i.e. don’t put all your eggs in one basket!).
Financial strength ratios help you determine how how well equipped a company is at paying their debts and other obligations like paying their suppliers and employees.
Again, as with the P/E Ratio and Price to Sales ratios, you should look at industry averages when analyzing a specific company.
The Current Ratio measures a company’s ability to pay its current liabilities, which are debts or loans that are due in less than a year. It is calculated as current assets divided by current liabilities. A current ratio greater than 1 means that a company’s assets are greater than their liabilities, so they are able to cover their liabilities. On the other hand, a ratio less than 1 means liabilities are higher so the company may not be able to cover its obligations. While this is not great, it doesn’t necessarily mean the company will go under. The company could potentially negotiate better payment plans, or borrow more money.
If you're getting lost, we will discuss the definitions of all of these other terms in the next section.
Debt to Equity (D/E Ratio) measures the company’s financial leverage. In other words, how much of the company’s assets are financed by debt as opposed to the value of stockholders equity. It is calculated as Total Liabilities divided by Stockholder’s equity.
Think of leverage when buying a house. Taking the example from the last post, let’s say you want to buy a house for $200,000. You only have $50,000 so you have to borrow the other $150,000. In this case, your Assets are $200,000, your Liabilities are $150,000 and your Stockholders Equity is $50,000. Your Debt to Equity Ratio is 3.0 (150,000/50,000 = 3.0).
A ratio higher than 1 means a company assets are financed primarily by Debt. This isn’t necessarily bad. As with someone buying a house, you just have to make sure the company can afford to pay the debt back. The current ratio is a good indicator of that.
There you have it!
You are now a finance pro! Really. Not many people understand basic finance principles, let alone financial statements. You are on your way!
Keep practicing on Pitly with the lessons and pick a company. Use those new skills to invest some of that fake money on your virtual portfolio.