Finding the Right Ratios
Financial ratios are simply one number from a company’s financial results divided by another. Simple yet extremely powerful. Ratios are like having a flashlight in a cave, so you should no longer stumble in the dark with your investments.
Ratios allow you to compare low-value stocks with large and well-known companies or compare a business with any of its competitors. They also enable you to track the health of the underlying company and see if it is becoming stronger or fading away.
Knowing just one value is meaningless. For example, is sales of $1.3 million good? It depends. If a billion-dollar company is only bringing in seven-figure numbers, that would be very bad, while it might be positive for the latest profitable stocks.
However, if you have the price-to-sales ratio (price-to-sales ratio, or P/S), you can clearly see whether the stock’s value is compelling or whether it is much more expensive than its peers. In fact, by using some simple financial ratios that work well with low-value stocks, you will provide a very clear picture of the operational results and future potential of the underlying business.
Finding the Right Ratios
When it comes to low-value stocks, only specific financial ratios are useful, but those that work will completely change your perspective. Since smaller and newer companies often do not generate profits, gross and net profit margins cannot be calculated, for example.
However, valuation metrics such as sales per share can be quickly obtained from recent financial results or found through an online financial portal. Look for stronger financial ratio values compared to the competition, as well as improving numbers from quarter to quarter.
There are six specific ratios that should help you evaluate low-value stocks. Let’s take a look at each one in turn.
1. Price-to-Sales Ratio (P/S)
By dividing the current share price of a profitable stock by the company’s annual sales, you will see whether the investment is overvalued or not.
For example, if the stock is trading at $2.50 and the company brought in $1 in sales per share for the year, that results in a price-to-sales (P/S) ratio of 2.5. Lower values are better than higher values, and anything close to 2.0 or less is compelling.
2. Current Ratio
This ratio is of immense importance with profitable stocks. By dividing current assets by current liabilities, you will see how able the company is to cover its short-term debts with short-term assets.
For example, imagine a company has $2 million in current assets and $1 million in current liabilities. Their current liquidity ratio would be 2.0.
Avoid any profitable stocks that have a current ratio below 1.0 or close to it. In fact, you should find investments that boast this value at 2.0 or more – the higher the value, the better.
3. Quick Ratio
While the current ratio takes all assets into account, the quick ratio only considers assets that can be quickly and easily utilized. This means it does not include items like inventory but instead focuses on cash, marketable securities, stock market investments, and accounts receivable.
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The quick ratio of current assets to current liabilities gives you an idea of how easily the company can cover what it owes in the short term.
If a profitable stock has $2 million in cash, $500,000 in accounts receivable, and $500,000 in marketable securities (stocks), divided by $4 million in current liabilities, a quick ratio of 0.75 will be generated.
$3 million in quick assets, over $4 million in current debt = 0.75. In this example, the company would not have enough to cover what it owes.
Always look for a quick ratio of at least 1.0, but preferably 2.0 or higher. Higher numbers are better.
4. Operating Cash Flow
This takes into account cash flow from operations, then divides it by current liabilities. This ratio shows how well a profitable company can cover what it owes in the short term (the next 12 months) using its cash flows.
Higher numbers are better than lower numbers, but values slightly below 1.0 are acceptable.
5. Inventory Turnover
This shows how effective the company is at producing and selling products. A company that produces and sells its inventory five times a year is twice as effective as a company that produces and sells its inventory only 2.5 times.
The inventory turnover ratio will vary significantly depending on the industry in which the company operates. An aircraft manufacturing company will have a much lower value than an ice cream shop. However, using the ratio in comparison with competitors, or conversely, the company’s previous periods will provide excellent insights.
6. Debt Ratio
This is simple but important. Just divide total liabilities by total assets. If the company has four times more value in assets than in liabilities, the debt ratio will be 0.25.
In this example, the company is in a strong financial position. Be cautious when you see debt ratios anywhere near 1.0. If you are selective, look for values lower than 0.5.
Source: https://www.thebalancemoney.com/penny-stock-proven-ratios-2637035
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