Chapter 6 - Anatomy of a Stock

What makes a particular stock better or more attractive than another?  How can you tell if a stock is a worthwhile buy?  What is its current price telling you?  Is it under-priced or over-priced?  These are the types of questions we will explore in this chapter.  In previous chapters we examined factors that make a stock (and its price) move up or down, factors such as the nature of the company itself, the demand for its products and services, the state of the economy, and the number and quality of competing firms all come into play.  In addition, we saw that large institutional investors such as banks and pension fund companies often buy and sell huge quantities of shares which usually has a significant impact on the price of a company’s stock.  Furthermore, the type of stock itself (i.e., a Growth, Value, Penny Stock, etc.) also has an influence on price.  Finally, company-related news can single-handedly move a stock’s price in either direction.  Choosing a stock based on these factors alone is insufficient.  Any good investor needs to dig a little deeper in order to see what lies beneath the surface.  Think of a stock like an iceberg.  Many investors pick stocks based on the information that is immediately apparent – the 10% that is visible above the surface.  Savvy investors, on the other hand, scrutinize the 90% that lies beneath the surface.  In this chapter, I will tell you how to do just that.  Moreover, you will learn how to use a few tools of choice to pick winning stocks.  Our first tool, the Annual Report, will help you gain more insight into a particular company and the nature of its operations.  Then we will cover Financial Statements and Ratios to understand what information the actual numbers (i.e., Sales, Expenses, Profits, etc.) give about the company.  Looking at numbers is essential, because numbers don’t lie.  They tell the true story.  And numbers are not subjective in nature like other kinds of company information.  Using simple financial ratios will also help us gauge the performance and financial well-being of a company.  Many investment and financial experts use what is called Fundamental and Technical Analysis to analyze stocks; I will only briefly describe what these are as they are rather complex in nature and well beyond the scope of this book.  Nevertheless, it is important that you have an idea of what fundamental and technical analyses are.  There are many books written on the subject. 

For now, let’s begin with an overview of fundamental and technical analysis, and then we will look at the Annual Report as well as Financial Statements and Ratios.

Fundamental and technical analysis

In the investment world, there are two schools of thought or approaches to analyzing and valuing stocks.  Fundamental Analysis looks at, well, the fundamentals of a company.  It is the cornerstone of investing.  Here we are looking at both qualitative and quantitative information about the company.  Quantitative information includes numbers found in the financial statements of the company such as sales, expenses, and profits.  In addition, quantitative analysis involves the calculation of financial ratios which helps us better understand what the numbers are really telling us.  In the next section we will go into great detail about these subjects, as they are a critical component when picking great stocks. 

Qualitative factors are more difficult to measure and include things that set a company apart from its competitors.  Innovative approaches, intellectual property (mostly trademarks and patents), a competent management team, a strong brand name such as Coca-Cola for instance, and reputation are but a few qualitative factors that help us assess the value of a firm.  In brief, fundamental analysis considers these qualitative and quantitative aspects to determine the quality of the investment.

Technical Analysis uses a totally different approach to analyze the viability of an investment.  Individuals who rely on technical analysis argue that there is no reason to perform fundamental analysis because all the factors are already accounted for in the stock’s price.  They evaluate stocks by looking at things such as recent price quotes, demand, volume traded, chart patterns, and market trends.  Unlike fundamental analysis, which uses a long-term approach to evaluate stocks, technical analysis is limited to a much shorter time frame since it focuses on the current behavior of the market.  Technical analysis is a tool used mostly by what we call Day Traders.  These are stockbrokers and investment houses that buy and sell stocks for profit in the short term.  They usually only hold on to stocks for short periods of time such as a few days, weeks, or months.  In general, I would advise you not to use a technical analysis approach as it is both quite complex and speculative.  Remember, as I mentioned in Chapter 5, that 80% of professional stock pickers (who most likely use technical analysis) make unprofitable decisions.  Instead, use fundamental analysis to base your investment decisions, as you will be investing for the long term based on sound information, rather than speculating in the short term.

The Annual Report

One of the most valuable sources of information about a company is its Annual Report.  All public corporations must prepare this report once a year in order to inform shareholders about their operations and financial performance for the last fiscal year.  It is an indispensable tool for the investor.  If you are shopping around for a stock, you will definitely want to take a look at the latest annual report for the company in question.  If you already own a stock, you should take a look at the company’s latest annual report to keep tabs on the company, its plans, and its financial performance.  What you find in the report will help you determine whether the company is worth holding on to given your expectations.  You can use the annual report to assess a company’s profitability, its potential for growth, to learn about its problems or challenges, or to find out about risks and other factors that may affect its performance and, inherently, its stock price.   But the first step to reading an annual report is to find it.  There are generally two sources from which you can obtain a company’s annual report.  The quickest and easiest way is to pay a visit to the company’s website.  There is usually an Investor Relations section that will contain the company’s previous annual reports as well as annual and quarterly financial statements.  They are usually available in PDF (Portable Document Format).  A second way to retrieve the annual report is to go to a website called SEDAR (System for Electronic Documentation and Retrieval) for Canadian companies or EDGAR (Electronic Data-Gathering, Analysis, and Retrieval) for American companies.  Links to both free services follow in the link box below:

From these websites you can also obtain financial statements, news releases, and company prospectuses.  They have a database containing financial documents of nearly every publicly-traded company in North America.

Finally, if you own shares in a corporation, you should receive a hard copy of its annual report in the mail.  Just make sure to specify to your broker that you want to receive a hard copy through regular mail.  If you are buying stocks via an online broker, make sure you specify this when you open your account and/or when you purchase the security.  Alternately, you can specify that you want an electronic version of the report via e-mail instead.  It’s up to you.  Personally, I like the hard copy because it is much easier to read and it usually arrives automatically in the mail so you don’t need to think about when it will become available.  Some annual reports are quite fancy, works of art perhaps, while others are quite bland or black and white.  The important thing, though, is to get the information you want.  Most annual reports contain the following sections:

1. Letter to the shareholders (from the CEO, President, or Chairman)
2. Highlights of the past year
3. Management discussion and analysis
4. Auditor’s report
5. Financial statements (the most important part)
6. Notes to financial statements
7. Corporate information

Now let’s take a brief look at what you will find in each section and what you should be on the lookout for.

1.  Letter to the shareholders

In this letter, the CEO, President, or Chairman, will tell you how the company fared in the past year and, more importantly, why.  It should state whether goals and expectations have been met for the last year and what conditions have changed along the way.  Try to get a sense of the tone in which the letter is written.  Is it positive, negative, or apologetic?  Try to spot any problems or potential for problems in the future.  Look for words like “Except for…”, “Despite the fact that…”, “Due to …” as these may be clues to problems and drawbacks.

2.  Highlights of the past year

Not all companies include this section in their annual report, but when they do it makes it easier to assess the overall performance of the company.  Are earnings and share prices up or down?  Beware, however, because the highlights don’t tell the whole story.  Make sure to take a closer look into the other sections of the report.

3.  Management discussion and analysis

This is usually the longest section of the report.  It may be filled with technical and financial jargon.  Here, the company and its directors will go into the nuts and bolds of what happened during the last year and how it affected the financial performance of the company.  Things such as changing currency exchange rates, interest rates, and even the weather can be blamed for setbacks encountered over the past twelve months.  If time is not on your side, you can always skip this section.  But if the company has had problems recently, you may want to further investigate them in this section. 

4.  Auditor’s report

This section is usually a standard component of an annual report.  Typically, the auditor’s statement is less than a page in length.  An auditor is an accountant from an independent firm who verifies the accuracy of financial statements and makes sure that proper accounting practices were followed in the preparation and reporting of financial statements.  It is imperative to have a neutral third party look over the firm’s accounting so that shareholders are given a fair, unbiased, and accurate account of events that have occurred.  Basically, the auditor’s report will tell you if the company has followed proper accounting practices and whether the figures found in the financial statements are accurate and truthful.  There are two things you can look for in this section.  First, is the auditor from a reputable firm in the field?  This may be difficult to assess.  But usually, big and successful companies hire reputable auditing firm representatives.  You can always google the firm on the Internet to see if any media has criticized the auditor’s operations, reputation, or integrity.  The second and most important thing to look for is any “red flags” in the auditor’s report.  Be on the lookout for phrases such as “Subject to …”, as this usually means that the auditing firm may be uncertain about some aspect of the company’s operations or finances and that it is relying on the company’s word.  Usually, when these two words make it into an auditor’s report, it spells trouble.  Watch for similar words or sentences that may indicate any uncertainties about the company’s operations or financial situation.

5.  Financial statements

This is undoubtedly the most important section of the report.  All the important numbers are found in this section.  And numbers don’t lie.  Since this is the most important section of the annual report, I will discuss it in greater detail in the following section.

6.  Notes to financial statements

Often, the most important pieces of information are found in the footnotes section.  This is where the company includes its “fine print”.  Make sure you read through this section as it will tell you about all kinds of happenings that occurred behind the company’s doors.  You will find a variety of information here, such as how revenue is recognized by the firm, changes in its accounting policies and practices, how stock options were issued and granted to managers, etc.  Read the footnotes carefully, as they may explain how and why sales, expenses, and profits, and the like have fluctuated in the past year or even longer. 

Footnotes are useful as they are a place where the company can expand on and further explain the numbers found in the financial statements.  Here, more qualitative information can be given to the reader to allow for a greater understanding of the company’s true financial performance and position.  For example, profits may be down due to an unexpected event such as an explosion at one of its plants.  Look for any special events that have occurred during the last year and try to determine the likelihood of unfavorable events happening in the future.

There are no clear standards on how footnotes are to be reported.  As a precaution, be suspicious of notes with technical, legal, and accounting jargon; they may be used to confuse investors.  It may mean the company has something to hide.

7.  Corporate information

In this section of the annual report, you will find information about the company itself, its structure, the location of its offices and facilities, a list of its management team members and their credentials, as well as stock-related information.  Do look for data on stock prices, dividend payments, and the like (if available), as you may get a better idea of where the company has been and where it may be headed, given the current management team. 

Finally, you need to ask yourself a few more questions about the annual report.  Is the report clear, concise, and to the point?  Is it attractive?  How is the company pursuing its sales and marketing efforts?  What are their plans for the future?  Are they pursuing new markets here or abroad?  Are there plans for expansion and diversification?  Are there any direct comparisons made with its competitors?  How does the firm compare with others in its industrial sector?

Financial statements and ratios

Companies are required to keep track of their financial performance by means of financial statements.  All public corporations must prepare and make available such statements to their shareholders on a quarterly (i.e., every three months) and annual basis.  Think of them as a report card where you are the evaluator instead of the one being evaluated.  Define your own standards for excellence!  It is your responsibility to work with the numbers found in these financial statements.  As a new investor, you need not be intimidated by all the numbers and accounting jargon found in these statements.  Most of these statements are fairly standardized and quite simple to grasp.  Often, the numbers alone don’t necessarily mean too much.  But when you compare them with those of competing firms, you gain more insight about the true performance of the company or companies you are evaluating.  There are many different kinds of financial statements in a company’s accounting system.  But there are three in particular that are of greatest importance: the Income Statement, the Balance Sheet, and the Cash Flow Statement.  Even though the structure or elements found in each is fairly standardized, there will be differences between companies of different sizes and lines of business.  But don’t worry, as the numbers we will be looking at are quite simple to find.  In a nutshell, we are looking for companies with solid and steady earnings, strong balance sheets, and positive cash flows.  Let’s begin by looking at the Income Statement and then we will continue with the other two.

The Income Statement

The Income Statement, sometimes called the Profit And Loss Statement, summarizes how much revenue the company received during the year (or quarter) from the sale of its products or services and all the expenses it incurred along the way.  The difference between revenue and expenses represents the company’s profit (or loss) for the period in question.  Profit is most often referred to as Net Income; it is usually indicated on the bottom line of the income statement.  In the world of business and investing you will often hear that companies and investors are concerned with “the bottom line”.  What they are really saying is that they are concerned with whether a firm made money.  It is referred to as “the bottom line” because it is the last line that appears on the income statement that tells us if the company has indeed made a profit.  A sample income statement appears below in Table 16 which is followed by Table 17, which explains each component found in the statement.

Table 16 – Sample Income Statement for XYZ Corp.

Table 17 – Income Statement components explained

Now let’s take a moment to analyze what is happening in our income statement found in Table 16.  Usually, companies include the numbers from the previous year (or quarter) next to the current numbers, so that we can make comparisons.  This is extremely useful as it permits us to see if things have improved over the previous period.  As you can see, Sales (also called Revenue) in 2006 have increased by 20% over those in 2005.  This is a good sign.  If you see a decrease in sales or revenue then that is usually a bad sign.  Cost of Goods Sold has decreased from 75% to about 64% of sales which is quite good.  In other words, it costs 11% less to produce goods in relation to sales.  This means that the company is more cost-effective.  Finally, Net Income has increased by a whopping 80%.  This is a very good sign, as the extra income can be used to further invest in the firm or be distributed as dividends to investors.  Take a moment to make comparisons of the other components to see whether the company’s situation has strengthened or weakened.  In general, you want improvements everywhere, but most importantly in Net Income.

Now let’s make a comparison between two companies.  This is useful if you are considering investing in one of two companies but you are not sure which one is the best buy.  Take a look at Table 18 that follows.

Table 18 – Comparison of Income Statements from two different companies

Notice I have simplified the income statement for each company by only including the figures for Revenue, Expenses, and Net Income.  Here, you want to look at two things.  First, you want to find out which company offers the highest earnings (net income) per share of stock.  And second, which stock renders the most value given its share price.  Let’s begin by comparing earnings between the two companies.  As you can see, net income made by Company A & B were respectively $60 million and $70 million.  You must keep in mind, though, that these earnings are distributed over a different number of owners (or shares).  Please note that you can usually find the number of shares the company has in circulation in the accompanying footnote from the Capital Stock or Share Capital component under the Shareholders’ Equity section of the Balance Sheet.  Since profits (or portions of) are distributed over a different number of shares, we must calculate them on a per share basis for each company in order to make a fair comparison.  Assume that Company A has 50 million shares while Company B has 25 million shares.  Now we are in line to compute our first financial ratio – Earnings Per Share (EPS) for each company.

As you can see, Company A made $1.20 per share while Company B made $2.80.  Obviously Company B made more profit on a per share basis.  It is always a good idea to compare EPS with those of previous quarters or years.  You want to see growth in this area.  So, are you ready to go and buy shares in Company B?  The answer should be: “No”, as we still have more work to do.

Now we need to determine which stock provides us with the most value given the price at which its shares are sold.  Assume the market price of stock in Company A is $20 while it is $90 for Company B.  We can compute the Price-To-Earnings ratio, or P/E ratio, to better compare the share price of the two companies.  We simply need to divide the market price per share by the earnings per share computed earlier.

In general, stocks that have lower P/E ratios indicate better value.  It is best to compare P/E ratios for companies that are in the same line of business as they tend to vary across industries.  Banks and utility companies, for instance, have lower P/E ratios than do more speculative industries such as gold mining and technology.  There is no set standard when it comes to P/E ratios.  Value investors look for low P/E ratios, while growth investors are comfortable with high P/E ratios.  Personally, I find this ratio most useful when comparing stocks of companies in the same line of business or even against the company’s own historical P/E ratios.

The Balance Sheet

Unlike the Income and Cash Flow Statements that reflect a company’s operations for a whole fiscal year (365 days), the Balance Sheet only represents a snapshot of the company on one given day at the end of the fiscal year.  A balance sheet is also prepared at the end of every quarter.  The balance sheet is sometimes called the Statement of Financial Position.  A quick look at the balance sheet will reveal whether a company is rich in assets or whether it is burdened by debt and at risk of not meeting its financial obligations.  The balance sheet summarizes a company’s Assets (what it owns), its Liabilities (what it owes), and Shareholders’ Equity (what is left over).  Given these three components, the balance sheet always follows the following formula, or accounting equation:

Assets = Liabilities + Shareholders’ Equity

Assets include what a company uses to operate its business.  Things like cash, equipment, land, and inventories are considered to be assets.  Liabilities include payments due to suppliers, loans and income taxes payable, dividends payable, long-term debts, and the like.  Shareholders’ Equity is comprised of the amount of money that was initially invested in the firm (including capital raised from the initial sale of company shares), plus any Retained Earnings.  Retained earnings are profits that have been reinvested in the firm.  Retained earnings are very important to any firm as they serve to further expand the business through the acquisition of new assets.  If you refer back to our formula above, Assets = Liabilities + Shareholders’ Equity, you will notice that there are two sides to the equation.  And these two sides must always “balance out”; hence the name Balance Sheet.  This makes sense because a company has to pay for all its assets by either borrowing money (liabilities) or by using funds from investors (shareholders’ equity).  Keep in mind that if you own shares in a company then you are a financial contributor in the company.  In other words, the cash you invested in the company is used by the company to purchase assets and pay liabilities.  As an investor, you want to make sure that total liabilities do not exceed the shareholders’ equity.  If total liabilities exceed shareholders’ equity, this will be a cash drain on the company because they will have to pay interest on the debt; investors will see this as a bad thing and will decide to sell their shares for fear of further losses which will, in turn, bring down the stock’s price, leaving you poorer.  This is why it is imperative for you to keep an eye on this particular aspect.  A different way of looking at the accounting equation would be to state it as follows:

Shareholders’ Equity = Assets - Liabilities

All you need to do is subtract Total Liabilities from Total Assets taken from the balance sheet to determine what the company is worth.  Compare the amount found in Shareholders’ Equity with that from previous years or periods.  You want to see this figure grow over time as it represents accumulated wealth for you the shareholder.

Before we learn how to analyze the balance sheet with financial ratios, let’s take a closer look at the anatomy of this financial statement.  Take a moment to examine the balance sheet of XYZ Corp. as appears in Table 19 below.

Table 19 – Sample Balance Sheet for XYZ Corp.

To describe each component on this balance sheet, I have included another table that follows.

Table 20 – Balance Sheet components explained

The first thing to notice on the balance sheet from Table 19 is that Retained Earnings have increased which is a good sign as this illustrates the firm’s cumulative earnings since inception (minus dividends).  When retained earnings are on the rise it means that the firm has more money to work with.  Similarly, we see an increase in Share Capital which is what you want to see.  Should this number be inferior to the one in the prior period see the accompanying note to find out why.  It may be due to a number of reasons such as poor sales or a sharp decline in the economy.  Don’t worry too much if it is due to a poor economy because all businesses move through cycles as explained earlier; it may only be temporary.  If it is due to poor sales, try to find out what happened and why.

Now we want to look at the company’s Current Assets (what it owns) versus its Current Liabilities (what it owes) in the short term.  By “short term” we mean for a period of one year.  Why do we want to look at this for one year?  Easy.  It is because all businesses plan their operations around the next year.  The balance sheet (as well as the cash flow statement) is used as a compass to prepare the company’s operating budget for the next fiscal year.  If the company wants to provide its shareholders with a good and healthy annual report at the end of the following year, then it must use the financial means at its disposal.  The balance sheet and cash flow statement will help determine that very amount.  If the company is low on cash, it may need to borrow more money or issue additional shares of stock to raise what we call Working Capital.  A company’s net liquid assets are referred to as working capital.  Essentially, liquid assets include cash, securities, accounts receivable, or any other assets that can be converted to cash in a very short period of time.  The working capital for a company can easily be computed by simply subtracting Current Liabilities from Current Assets found on the balance sheet.  As a general rule of thumb, you want current assets to be twice as large as current liabilities.  We use the Current Ratio (also known as the Working Capital Ratio) to measure that:

From our sample balance sheet in Table 19 above we can see that XYZ Corp. has a current ratio of 1.57 (i.e.,: $5,195,300/$3,300,000), which is a good ratio.  A ratio of 1 or less indicates a negative working capital; it means that the company has more current liabilities and fewer current assets to operate with.  A ratio of 2 is ideal; it means that the company has $2 in current assets to pay for each $1 of current liabilities.  Ratios above 2 are certainly acceptable, but you would rather see the company investing the “excess cash” in new equipment or something that will help it grow further.  Similarly, an investor should invest $20,000 that is sitting in a low interest savings account into a more profitable investment vehicle.  So, in general, you want to look for a Working Capital Ratio that lies somewhere between 1.2 to 2.  Of course, this depends on the industry but it is still a good yardstick.

Now we want to look at longer-term debt.  More precisely, we want to compare long-term debt with the company’s capital (equity).  The ratio of choice for the task at hand is the Debt-To-Equity ratio.

This ratio measures a company’s total long-term debt as a proportion of the shareholders’ equity.  It is a key measure that can be used to see if a company’s borrowing is excessive.  Excessive borrowing is undesirable because lots of expensive interest payments will have to be made in the future.  By looking at figures from our balance sheet in Table 19 above, we can easily compute a ratio of 0.23 (i.e.,: $1,150,000/$4,995,300), which is excellent.  If the ratio is 1 it means that the company’s long-term debt and equity are equal.  With the debt-to-equity ratio, the lower the ratio, the better.  You definitely want to see a ratio that is less than 1.  But ideally, you want twice as much equity as debt, or a ratio of 0.5 (or less).  A ratio of 2 or higher can spell trouble.

We still have a little bit more work to do with regard to evaluating a company’s debt.  Should a company, perhaps one you already own, be burdened with a significant amount of debt, don’t sell it just yet.  You need to find out what the additional borrowed money or debt is used for.  If it is used to purchase income-producing assets such as equipment, land, buildings, a production plant, or even to acquire another company, then that may be a good thing as it is likely to pay off in the future.  If the money is wasted on things such as heavy compensation and corporate bonuses to company officers, then that’s bad.  Be sure to read the corresponding footnotes about long-term debt in the annual report.  In short, quality companies will ensure that their long-term debt decreases year-over-year.  If you can, try to get the figures from prior periods to see whether it is the case.  And why not do the same for other ratios?

The Cash Flow Statement

Publicly-listed companies are required to prepare a Cash Flow Statement in order to disclose their cash positions to investors more clearly.  Cash is an important component of any business.  Without it, a company would not be able to pay for the materials, goods and services, or any other asset it requires to operate.  As an informed investor, you want to know the cash position of the company or companies you own at all times.  Should a company run dangerously low on cash, it may find itself on the brink of bankruptcy, leaving its investors with a substantial loss on their investment.  Each and every year, many companies sadly encounter that very fate.  That’s why you must keep an eye on the cash position of any investment or potential investment.  Simply put, the cash flow statement summarizes a company’s yearly cash receipts (inflows) and cash payments (outflows).  In other words, it tracks what money is coming into the business, from where it is coming, and how it is being spent.  For nearly all businesses, cash flows from three distinct business activities: operations, investing, and financing.  And that is why all three are listed as main sections in the cash flow statement.  Cash flow from operations consists of all cash transactions involved in the buying and selling of goods and services.  In short, it reflects how much cash is generated from the sale of the company’s goods or services.  This should be the source from which the company raises most of its cash.  If it is not the case and most cash is raised from the other two business activities, then this may be a bad sign (unless we are talking about a startup company).  You want to see a positive year-over-year increase in cash from operations. 

Cash flow from investing includes the purchasing and selling of long-term investments such as property, plants, equipment, and other productive (fixed) assets.  Increasing investments indicate the use of funds while decreasing investments represent a source of funds for the company.  In this section you will likely see a negative cash flow which is good if the cash was spent to purchase income-producing (fixed) assets.  So don’t worry if you see a negative cash flow in this section, as it is quite normal.  You may even see an entry for the acquisition of another business which may prove positive for future growth.  

The third section reveals cash flows from financing activities.  Cash inflows include capital raised from borrowing or issuing company stock or bonds.  Cash outflows mostly consist of the retirement or repurchase of bonds or stock and the payment of cash dividends to owners of the firm.  Here you want to look for repayment of long-term debt and, as much as possible, the absence of new stock or bond issues.  You don’t want to see a company that you own issue additional stock, as this automatically decreases the value of your existing shares.  This is especially the case if the company pays regular dividends.  I will not include a sample cash flow statement in this section because they vary too much from one company to another.  Just be sure to take some time to examine it for each company you own or are considering buying.

More financial ratios please!

In the previous section we looked at four useful financial ratios (Earnings Per Share, Price-to-Earnings, Current Ratio, and Debt-to-Equity).  These are all very important ratios to use when evaluating stocks.  But there are a few more that we need to consider in order to have a more complete screening process for evaluating the quality of company stock.  The first two ratios we will look at are concerned with how effectively the company and its management team are utilizing the company’s resources in order to generate revenue.  Return On Assets (ROA) and Return On Equity (ROE) represent the ideal ratios for the task at hand.  Return on assets reveals how efficiently and effectively the company uses its fixed assets to generate profit.  ROA is easily computed by dividing Net Income by Total Assets.  We can use our example from above to compare ROA from Company A and Company B.  In doing so, assume that Co. A has Total Assets equal to $9,500,000 and Co. B to $6,500,000.

As you can see from the calculation above, Co. B has generated a greater return on its existing assets.  In other words, it makes more money, proportionally, than does Co. A.

Return on equity is very popular among professional investors.  ROE indicates how much profit is generated with the money shareholders have invested in the firm.  Moreover, it indicates to shareholders how much bang they are getting for their buck.  ROE is calculated by dividing Net Income by Shareholders’ Equity.  Once more, let’s use our example from above to determine whether Company A or Company B has the greater ROE.  Assume Co. A has Shareholders’ Equity of $5,000,000 while Co. B has $4,650,000.

In this case Co. B generates more return per dollar invested by its shareholders than does Co. A.  Many financial experts argue that firms with ROEs greater than 15% are good picks.  As a wise investor, you not only want to look for firms with good ratios, but rather, firms with consistently good ratios. Be sure to compare ratios for the past few years in order to get a more complete picture of the company.  It is also a very good idea to compare ratios with industry averages; I will tell you how to do so shortly.

The last two ratios we want to look at are concerned with Dividend Stocks.  These ratios are particularly useful when you are shopping around for high-paying dividend stocks.  Here, we want to find out which companies share more of its earnings with investors.  The first ratio, the Dividend Yield, is calculated by dividing the Annual Dividend Per Share by the Price of the stock.

With dividend yield, the higher the ratio, the better.  But the dividend yield doesn’t tell us what proportion of earnings the company pays to its shareholders.  The Dividend Payout Ratio, however, does just that.  It is an indicator of just how much wealth the company is sharing with its shareholders.  Moreover, the dividend payout ratio represents the percentage of net income that is paid to shareholders in the form of dividends.  In this case the higher the ratio, the better.  The dividend payout ratio is determined by the following equation:

 Annual Dividend Per Share can usually be obtained by consulting the company’s annual report.  Alternately, it can be computed by adding together all dividends that have been paid in the year on a per share basis.  Often, companies pay dividends every quarter (three months).  Dividend-related information is also usually available under the Investor Relations section of the company’s website.

There are many more kinds of ratios, but suffice it to say we have covered, in my opinion, the most important ones.  For your convenience, I am including a summary of ratios below (see Table 21).  I have grouped the ratios by category (i.e., Profitability, Liquidity, Valuation, and Efficiency), and added some that we have not covered in order that you may further explore the exotic world of financial ratios.  In addition, I am providing you with a few links to sites that cover this topic.  Pay close attention to the Reuters website as it is very thorough.  Not only does it provide a thorough explanation of all the different financial ratios, but it also provides computed ratios for most publicly-traded companies in North America.  In other words, it does all the dirty work for you.  All you need to do is specify a particular stock and click on the Ratios link found in the menu on the left-hand side of the website.  You can even compare ratios with industry and sector averages as well as with the market as a whole.  In addition, Reuters provides a link called Financial Statements on the left-hand side of the menu from which you can access the latest (and previous) financial statements of the companies you are looking at.  And the best part is that it is all free.  Thanks, Reuters, for providing us with a real gem of a site!

Table 21– Summary of Selected Financial Ratios

This concludes our discussion for this chapter.  Hopefully, you have gained a better understanding about what really makes a particular stock sparkle and shine as opposed to what makes one an unworthy investment.  By all means, use the tools that I have provided you with in this chapter to both keep track of any stocks you may already own and for those you are considering buying.  Many investment-related magazines, many of which are listed in Appendix A – Investment Resources, often use the same tools and ratios I have described in this chapter to rank stocks for their readers.  Next time you pick up one of these magazines, you will be in a better position to understand the financial lingo that is often used in them.  You are one step closer to becoming an investment pro.

© Dan Fournier, 2007-2011