How to Read Financial Ratios And Identify Great Stocks Part 1: Profitability & Returns
You may have read our guide to Ultimate Beginner’s Guide to Picking Your First Stock, and now you know a bit more about stock picking.
But the time has come for you to take things up another level to analyse and identify great stocks!
Here, we will show you the must-know financial ratios to analyse a stock, using Starhub Limited’s financials in 2018 as an example.
Disclaimer: This post may get pretty technical, but we will try to break it down into digestible pieces!
This is part one of a two-part guide on how to analyse stocks using financial ratios. Here is part 2: How to Read Financial Ratios & Identify Great Stocks Part 2: P/B and P/E Ratio & Liquidity Ratios.
When you buy a share, your returns will come from two places.
- Capital gains from the increase in share price
As a result:
Total Shareholder Returns = Increase in share price + Dividends over the same period
Dividend yield = Dividend/Share price
But do take into account the movements in share price as well, which relates to the fundamentals of the stock.
Take Starhub for example, their share price reduced 3x in four years.
Their dividend yield is pretty high (over 10% for the past few years), but that’s because share price tumbled, rather than an increase in dividend! In fact, their dollar dividend actually decreased.
Taking share price of $1.48,
Dividend yield = 0.04/1.48 = 2.70%
Dividend payout ratio = Total dividends paid out by company/Net Profit
Dividend payout ratio = 276.9m/200.6m = 138%
Do check whether the dividends paid is sustainable.
Like for the case of Starhub, their dividend payout ratio for 2018 is more than 100%… It means that whatever they had earned, they paid out to shareholders as dividends. You may say, “But… That’s good, right?”
That may sound good for you as a shareholder now.
But, this does not make sense in the long-term for the company as it means that the profits earned are not retained for the use and growth of the company.
On top of that, a payout ratio of near 100% (and in Starhub’s case, over 100%) is definitely unsustainable!
Dividends will decrease eventually. Especially since they do not retain their earnings which could have been used to purchase assets to bring revenue.
Net profit margin = Net profit/Revenue
It shows you the percentage of revenue that has turned into profits. It is how much the company gets to keep after deducting costs incurred.
Profit margin = 200.6/2362 = 8.49%
So… What is a good profit margin? If you have read Seedly Chicken Rice’s Income Statement, you will realise that their profit margin of 25% is considered pretty high.
A good profit margin will vary by the industry of the company, but if you read any of our stocks discussions, you will notice the profit margins average around 10%.
Return On Equity
Return on Equity = Net Profit/Total Equity
Return on Equity shows you how efficient the company is using its equity to give profits.
Return on Equity = 200.6/588 = 34.11%
You can also look at it using the Du Pont Analysis, where the ROE is broken down into parts.
Du Pont Analysis:
ROE = Profit Margin x Asset Turnover x Equity Multiplier
Profit Margin = Profit/Revenue
This shows you the operating efficiency of the company.
Asset Turnover = Revenue/Total Assets
This shows you the efficiency of use of assets, or how the company uses the assets to generate revenue.
Equity Multiplier = Total Assets/Equity
This measures the financial leverage used by the company.
The Du Pont Analysis allows you to break down what the main drivers for Return on Equity are and what is the component driving the returns.
Return On Assets
Return on Assets = Net Profit/Total Assets
Total assets = 1704.70 + 930.8 = 2,635.5
Return on Assets = 200.6/2635.5 = 7.61%
The higher the ROA, the better the company utilises its investment in assets to give returns.
The difference between ROE and ROA is that ROA accounts for both equity and debt of the company.
Such metrics can be compared across companies in the same industry. A food & beverage company would utilise their assets differently from a technology company.
Return On Invested Capital
ROIC = NOPAT/Invested Capital (where NOPAT = Net Operating Profit after Tax)
NOPAT = 273.5 x (1-0.17) = 227.01
Operating profit is also referred to as earnings before interest and tax (EBIT). Using NOPAT as the numerator will help us to focus on the income generated from business operations only. Since a company can have other income (e.g exchange differences), using the net profit cannot really tell us which segment the income is coming from.
Invested Capital = Debt + Equity – Cash
Invested capital = (50.1+978.4) + 588 – 166 = 1,450.5
ROIC = 15.65%
Seems like their return on capital is pretty alright!
ROIC should be compared to a company’s cost of capital to determine whether the company is creating value. A firm’s weighted average cost of capital (WACC) just means how much they are paying for their capital, weighted by the percentage of debt and equity.
We want to see ROIC being greater than WACC, because that would mean the returns are higher than the costs.
A higher ratio for the company would be better for you as an investor.
But when the dividend payout ratio numbers get too high, it may be a red flag and a sign for you to read into their annual report to understand more.
Please always do your own due diligence!
This is part one of a two-part guide on how to analyse stocks using financial ratios. Here is part 2:
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.