Fundamental valuation ratios
The profitability of a publicly traded company drives the value of its equity as investors primarily care about the profits their investments generate. For example, the most common ratio is the Net Profit Margin - of the revenue generated, how much is profits? Additionally, Return on Investment measures the amount of profit made on an investment. Both these ratios are important for investors prior to investing because they can understand the profitability of a company or the cost structure (the inverse of profit).
Additionally, profitability ratios can be used to understand what percentage of the revenue is available to cover expenses. This is calculated using the Gross Profit Margin, which looks at how much money is generated to cover expenses after the cost of goods are subtracted from the revenue.
Net Profit Margin =Net IncomeRevenue
Return on Investment = ProfitInvestment
Gross Profit Margin = Gross ProfitRevenue
*You can find these values on the company’s balance sheet/income statement*
Liquidity ratios focus on the company’s ability to meet its short term obligations and this varies by industry. Investors prefer companies with high liquidity ratios but larger companies can get away with lower liquidity ratios because of greater funding sources, compared to smaller companies. During the peak of the pandemic, the US federal government pumped liquidity into the economy with interest-free loans to institutions and stimulus payments to individuals.
Current Ratio = Current AssetsCurrent Liabilities
A higher ratio is preferred because it indicates a company has liquidity, more capacity to take on debt and meet its short-term obligations.
Another helpful measure is the cash conversion cycle, which calculates the number of days it takes for a company to collect cash. Operations with a lower cash conversion cycle will have greater cash on hand and hence liquidity.
The defensive interval ratio measures how long a company can pay its daily cash expenditures with only existing liquid assets (no additional cash flows).
Defensive Interval Ratio = Cash + Short Term Marketable Securities + Receivables Daily Cash Expenditures
On the other hand, solvency ratios focus on a company’s ability to meet its long term obligations such as debt. The amount and type of debt a company holds will influence their future risk and return. This measure is known as leverage and there are 2 kinds. Operating leverage comes from fixed costs like building rent and financial leverage arises from financing costs like interest expenses.
A commonly used measure is the debt-capital ratio which measures what percentage of a company’s total capital is financed by debt.
Debt-to-Capital Ratio = Total DebtTotal Debt + Shareholder's Equity
On the financial leverage side, the interest coverage ratio (aka Times Earned Ratio) represents how many times earnings before interest and taxes (EBIT) can cover the interest payments.
Interest Coverage = EBITInterest Payment
This metric looks at the relationship between the market value of a company and a financial metric like earnings. The aim is to show you the price you are paying for some future stream of revenue/cash flow. For example, if you pay $100 for a company that expects to generate $200 a year, then the company is cheap because the P/E ratio is 0.5x (the S&P 500’s P/E ~18x). Essentially, valuation ratios are based on estimates of future streams of cash flows/earnings.
Since these ratios are forward looking, you will have to make an estimate about what you and the rest of the market believe this company could potentially generate. Analyst expectations about future earnings can easily be found online and play a role in the movement of an asset’s price.
The most commonly used measure is the Price - Earnings ratio (also known as P/E or PE ratio) which looks at how much an investor pays for a single dollar of earnings. This ratio is also beneficial to compare competitors within the same industry.
Another major valuation ratio is a company’s enterprise value to its earnings before interest, tax, depreciation and amortization (EBITDA). A company’s enterprise value measures the total value of a company and is calculated by adding debt and subtracting cash from a company’s market value. Overall, the ratio tells you how many times a company’s EBITDA covers the value of the business.