How to Use the Top 3 Financial Ratios

07/20/2012 9:00 am EST

Focus: MARKETS

Patrick McKeough

Editor, Successful Investor

When you cross the line between listening to what people tell you about stocks and evaluating stocks for yourself, this is the holy trinity of ratios; the essential building blocks of all other fundamental data, observes Pat McKeough of TSI Network.

When you know what to look for with these three financial ratios, you improve your chances of uncovering the best value stocks.

When you look for stocks that are undervalued, it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.

High-quality value stocks like these are rare and hard to find, even when the markets are down. But when you know what stocks to look for, you can discover them. We employ three financial ratios as a useful guide to spotting them:

Price-to-Earnings Ratios
The P/E is the ratio of a stock’s market price to its per-share earnings. Up to a point, the rule on P/Es is “the lower, the better.” However, a suspiciously low P/E can signal danger rather than a bargain.

But a P/E around 10 often represents excellent value, assuming there are no danger signs such as a failure to keep up with the competition, or signs that the company has made an expensive mistake with an unwise major expansion or acquisition.

We start by calculating each P/E ratio using the most recent financial data. But we then go on to analyze the “quality” of the earnings.

For instance, we disregard a low P/E ratio if it is due to a one-time capital gain on the sale of assets, since the gain temporarily puffs up the “e”. (That shrinks the overall P/E.) Similarly, we add back any one-time earnings write-offs, so we don’t miss out on stocks that would have had low P/E ratios if not for one-time write-offs.

Always remember that a low P/E can be a danger signal. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why it’s crucial to look at P/E ratios in context. We check to see if other financial ratios confirm or contradict the value of this popular ratio.

Price-to-Book-Value Ratios
The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value.

This ratio captures a “snapshot” of an instant in time, and could change the next day. Asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation. (So certain kinds of assets on a balance sheet might have actual market values well above historical values, as can happen with real estate or patents.)

When we find a stock with a low price-to-book value, we look to see if the price is too low, or if its book value per share is inflated. Often, we find that the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, which means they may be in danger of being written down.

Price-Cash Flow Ratios
Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is a measure of the cash flowing into a company less cash outlays.

Simply put, it’s earnings without factoring in non-cash charges such as depreciation, depletion, or the write-off of asset values. Cash flow is particularly useful in valuing companies in industries in which depreciation and depletion charges are based on the historical value of assets rather than the current value. This occurs in industries such as oil & gas and real estate. As with any financial ratio, you have to look at it in context.

Once we’ve found a company that looks attractive using the financial ratios detailed above, we look to see if it has a solid business in an attractive industry, with a history of sales and earnings, if not dividends.

Even a stock whose financial ratios look good can stagnate if the company or its industry is in a difficult period. But if it’s a high-quality company, it’s likely to hold up better than other value-priced alternatives. Better still, it may be first to move up when conditions improve.

Editor's Note: Which ratios do you find to be the most valuable? Do you use any or all of the 3 ratios discussed above? Do you follow more technical indicators than fundamental ones? Let us know below in the Comments section.

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