In this article, we continue to look at the key financial ratios. In addition to the debt ratio, which we discussed in Part 1, it’s essential to understand if the company's management is effective and if the market price is reasonable. This is why ROE and P/E are so important.
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Explanations and definitions of terms.
Return on Equity of the Company (ROE)
The profitability of any company can be calculated by dividing the company's net profit by the desired indicator. Consequently, the return on equity (ROE) is calculated as the net profit ratio to the company's (stock value) capital. Thus, ROE shows what proportion of net profit falls on equity capital. The higher the ROE, the better.
Consider the following example:
For 2020, Company A made a net profit of $100 million. Company A has a net worth of $1 billion.
This means that the return on equity (ROE) = 100M / 1B = 10%.
For 2020, Company B made a net profit of $100 million. Company B has a net worth of $2 billion.
This means that the return on equity (ROE) = 100M / 2B = 5%.
Conclusion: company A is more attractive for investment.
We recommend focusing on the following principles when choosing a company:
- It is best to pay attention to the average ROE over a period of time of 3-5 years
- The higher the ROE, the better. It is best to choose a company whose ROE is not lower than 10-15%
Consider the ROE of companies in the FAANG sector that we discussed in Part 1.
P/E Ratio: Overbought or Oversold Stock Price
Now that we understand debt and return on equity ratios, let’s move on. One downside to the previous indicators is that they don't answer the question of how overpriced or underpriced a stock may be. This is one of the most important questions when deciding whether to buy or sell a company’s stock.
Let's go back to our previous example of Company A and Company B.
Suppose company A has 1,000 shares. In the past reporting period (2021) company A earned $1.5 million in net income.
Company B has 1,500 shares. In the past reporting period (2021) company B earned $2 million.
The share prices of both companies are the same.
Let's now add one more indicator to the conditions of the problem: the price.
Company A's share price is $3,000.
Company B's share price is $1,000.
The question is which company is more attractive for investment?
To answer this question, we first need to calculate the EPS. It is calculated as the ratio of a company's net income to the number of its shares.
Company A's EPS is $1,500.
Company B's EPS is $1,333.
To understand whether the price of the shares of companies A and B is high or low, you can use the market value ratio P/E.
It is calculated as follows: P/E = Price/EPS. It can also be calculated in another way: P/E = company capitalization/net income.
From this formula, it becomes clear that P/E characterizes the company's net profit that will be required to recoup the value of the business. Or, to put it more simply, the number of years it takes to recover an investment in a business. The lower the P/E, the better.
Let's go back to the example:
P/E of company A = 3000/1500 = 2. If we buy the entire company, it will take 2 years for the business to pay us back and break even.
The P/E of company B = 1000/1333 = 0.75. If we buy company B, then it will take 0.75 years for the business to pay us back and breakeven.
Thus, it turns out that company B is more attractive in terms of P/E.
It is very important to mention that in this scenario, companies A and B must operate in the same sector. It would not be entirely correct to compare the P/E of companies that do business in different industries. In this case, it is better to compare the P/E of a particular company with the average P/E in that particular industry.
Let's look at FAANG stocks in terms of P/E.
|Company||P/E ratio||P/E ratio in the Industry|
As you can see, all companies in the FAANG sector have a P/E lower than in the industry. However, if we choose between stocks of a sector, then it is better to choose the stocks of the company with the lowest value. Judging by the figure, it can be seen that this is either shares of Meta or Netflix.
So, what stocks to choose? Let's summarize. We studied three key financial ratios for investors: debt ratio, return on equity, P/E.
The most lucrative stocks are those with:
- A minimum debt ratio
- The maximum value of ROE
- Lowest P/E compared to industry average
In the case of shares in the FAANG sector, we have the following picture:
- Meta has a very low debt ratio (24.7%), an ROE that is higher than Amazon and Google but lower than Apple and Netflix. The company's P/E is significantly lower than in the industry. The company's shares are attractive to buy.
- Apple leads in ROE (64%), but also has the highest debt ratio (82%) and the company's P/E is comparable to the industry. Among FAANG, it is not the most interesting option.
- Amazon leads in P/E. Just think - it takes half a century to recoup investments in Amazon. In terms of ROE, the company is in the second to last place, and the debt ratio is approaching 70%. Not the best choice.
- Netflix has earned a rather low P/E (17.92) due to a strong fall in its stock price. The company's ROE is in second place out of FAANG stocks (30.21%), while the debt is within the normal range (about 64%). A good stock to invest in.
- Google has the lowest ROE (15.82%), but the company's debt is also not high and amounts to only 29.9% of assets. However, the company operates in the same sector as Meta, and the company's P/E is higher at 20.17. So, compared to Meta, the company's shares are less attractive to buy.
Now you can apply your knowledge of fundamental analysis ratios to trading on Olymp Trade. Olymp Trade’s Stocks mode is perfectly geared towards longer term investments and portfolio and wealth building.Trade Stocks
Risk warning: The contents of this article do not constitute investment advice, and you bear sole responsibility for your trading activity and/or trading results.
Earnings per share (EPS) is a company's net profit divided by the number of common shares of stock it has outstanding.
Additional context for the visuals.