3 Key Ratios to Look for When Value Investing

Hey everybody! I hope you’re all having a good week, and if you’re not, fear not because the weekend is almost here. Today I am going to run through how I would begin to analyze a potential stock that I am considering purchasing. When I first start trying to evaluate a stock there are three key financial ratios that I like to look at that quickly tell me whether a stock is worth my time to take a closer look at. When I am doing my preliminary screening I like to use Google Finance because it is easy to search up a stock and the financial information that can quickly tell me if I am interested in a stock is easy to find.

There are three ratios which are the most important indicators of whether a stock is a good investment. These three ratios quickly tell us if a stock is a potential good investment. The 3 main ratios I like to look at are the P/E, the EPS, and the D/E ratios. However, the company also has to provide some qualitative attributes.

A Competitive Advantage

Before I even look at the stock’s ratios and financial factors, I want to find a company that has something called a competitive advantage. A competitive advantage  is something that separates your company from other companies from its competitors. This advantage has to be something that will continue to be relevant well into the considerable future.

For example, today we are going to analyze Apple (AAPL). I believe Apple has a durable long term edge due its closed ecosystem. This means that all Apple software is reviewed by the company itself. Since Apple plans on continuing to maintain a closed ecosystem, this qualifies as a competitive advantage. This type of analysis is called qualitative analysis. Qualitative analysis is when one analyzes a company by looking at qualities and attributes that are hard to put a number on.

After I have found a company that I believe has a competitive advantage I will begin do a quantitative analysis. All this means is that I am going to look at some of the numbers in a company’s financial statements to get a better understanding of how a company runs. This is an important part of analyzing a stock. For those of you who are cringing at the word “numbers”, don’t worry, the math is very simple and easy. The first thing I like to pull up the company on Google Finance. To continue with our Apple example, here is what AAPL’s Google Finance page  looks like at the time of this article:

Learn about ratios like Apple's P/E ratio

The P/E Ratio

The first thing that tends to jump out at you when you looks at is the big red or green number beside the price telling you how the stock did that day. Ironically, this number has virtually no use for the long term value investor. Instead the first thing I look at is the P/E ratio . This is the price that the stock is trading at, divided by the earnings per share. Basically it tells us how expensive the stock is compared to how big the company’s profits are. The P/E ratio is an excellent indicator of whether a stock is over or under priced.

Since the goal of the value investor is to buy great companies at discount prices, the P/E can help you see when a great company is “on sale”. I like to look for a P/E that is under 16 minimum and ideally under 14. If a company has a P/E over 16 I usually won’t even consider it. In this case, AAPL has a P/E of 10.50, so it passes this first test. If a P/E is not listed, it usually means that the company has negative earnings, which is also an automatic fail.

The EPS Ratio

The next thing I look at is the EPS. EPS is an acronym which stands for Earnings per Share. It is calculated by dividing a company’s profits by the number of shares outstanding. This tells us how much money the company makes. This needs to be positive, and high enough over zero that a small fluctuation in earnings would drive it negative. The entire purpose of a company is to make money, so the amount of profits a company makes is a determining factor of its quality. At the time of writing AAPL has an EPS of 8.99, well above zero, so AAPL passes this test as well.

Since AAPL passed the P/E and EPS tests, we need more financial information. Personally I like to use Morningstar to view financial records. All the financial information I could ever need is found on Morningstar. In addition Morningstar has a more user-friendly format than most financial databases. 

The D/E Ratio

When looking at a stock I have 3 key ratios where a stock must meet my criteria. If the criteria are not met I will not consider the stock. The final of the 3 key ratios is the D/E ratio. The D/E ratio tells me how leveraged a company is. This makes the D/E ratios the best indicators of a company’s risk of going bankrupt and its stock becoming worthless. The calculation of the D/E ratio is total debt divided by shareholder’s equity. I personally will not purchase a stock with a D/E over 1, and the lower the D/E the better. The D/E ratio can be found on AAPL’s Morningstar page under the Key Ratios section and the Financial Health subsection at the very bottom of the page. At the time of writing AAPL has a D/E ratio of 0.45, which is very good.

Ratios like debt to equity are important for companies like Apple.Quick Note:  When looking at debt to equity, I would recommend looking at the balance sheet. The balance sheet will tell you the total liabilities. If you divide this by shareholder’s equity, you get a more conservative debt to equity ratio.

By sorting through these three criteria, I can quickly determine if a stock is worth looking at more closely. These ratios give me a good idea of whether or not the stock is worth investigating further.  For a free  and easy to use cheat sheet, join our Insider’s list on the front page of our website. Next week, we’ll dive even deeper into stock analysis.

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