The most important skill that any investor needs to develop in order to have a successful investing journey is the ability to analyze a company’s fundamentals carefully and in a conservative way. An investor that fails to analyze fundamentals in a conservative way can easily overpay for a stock. The end result would be lousy returns or even worst, losing money. Analyzing fundamentals is a crucial skill especially to individuals that are interested in long term investments or strategic approaches such as value investing or dividend income reinvesting.
There are many ratios that are used to analyze stocks. When using them the investor should always compare the results from a company with the results from another and the results reported by the company in the past. Keep in mind that many of these ratios don’t really have any significance on their own unless they are compared to those of a different company or other ratios from the same company. Legendary investor Warren Buffett is an expert in financial statement analysis and some of the ratios he uses often are inventory turnover ratio, return on equity, return on invested capital, price to earnings and earnings per share among others.
In his value investing strategy Buffet searches for stocks that have a high return on equity, high return on invested capital and that have a high inventory turnover ratio or high profit margins. When he finds a company that meets these criteria he takes a look at the company’s earnings per share to determine the stability of the company. From the earnings per share information he can quickly determine if the stock can be a possible investment in the near future. He looks for increasing earnings per share ratios in a company’s historical earnings information and looks for periods with odd results compared to others. If he finds that a stock’s earnings per share went down in a year or two he finds the necessary information and studies it to know what happened during that period.
How Warren Uses Financial Ratios to His Advantage
Price to earnings
Warren adheres to his value investing philosophy, a philosophy he learned and mastered from one of the greatest investors of all time called Benjamin Graham. Benjamin was Warren’s mentor and he strongly believed that what you pay for and investment will ultimately dictate the return. When it comes to value investing, price is the most important factor after determining if a Credit: http://www.freedigitalphotos.net/images/view_photog.php?photogid=2026company has a durable competitive advantage or not. When Warren finds a company that catches his attention he waits patiently for the stock to fall to the price he determined he was willing to pay relative to the earnings of the company. A metric that establishes the relation between the price of a stock and the earnings of the company is the price to earnings ratio.
If the stock falls to the price he concluded in his valuation or lower, as long as the stocks fundamentals remain sound, he makes his move. But if the stock remains at a higher price than the one he was willing to pay he keeps his calm and continues researching the fundaments of other companies.
Return on equity
Usually the companies that Warren invests in have high returns on equity (ROE). The higher the return on equity the better. Companies that have a high ROE tend to perform better that those with a low number. To put it this way, a company that has a high ROE that has been constant over the years will be a lot better at redeploying retained earnings to increase shareholder value and ultimately profits for investors. Imagine that there are two companies that earn $1000000 in net income a year and retain all earnings to fuel expansion. One has a ROE of 25% while the other has a return on equity of 10%. If all the income is reinvested by the companies the one that has a ROE of 25 % would earn an additional $250000 the next year while the one that has a ROE of 10% would only produce an additional $100000. Over the years the difference would be huge in terms of total return. Companies that have good competitive advantages usually are the ones that have high returns on equity.
Inventory turnover and profit margins
Warren likes companies that have a high inventory turn over or high profit margins. Some of his investments who follow these criteria are Coca Cola, Yum Brands and in the case of relatively low profit margins but super high inventory turnover we have Wal-Mart. The faster a company sells its product and the higher the profits from each product the better. This is no rocket science but many investors are driven by hype and fail to analyze ratios as important as these. One company that is not a Buffett investment but that has high profit margins and blazing fast inventory turnover is Microsoft even when the price has tanked over the last ten years. At some point or another it is possible that the price will rise as long as the company keeps these ratios as high as they are today.
In conclusion, analyzing these ratios can tell you a lot about a company and while it is impossible to predict the future they can give you an idea of how a company performs. These are only some of the ratios that Warren and a lot of value investors use when making buy and hold decisions. Others that are very important are debt to equity, return on invested capital, and earnings per share growth among many others. You should also be careful about not paying too much for a stock relative to earnings as this can be disastrous to your wealth especially if you are investing for the short term.
Disclosure: This article is for educational purposes only and is not buy and sell recommendation. Always use your own judgment when making your investments or seek help from a certified financial advisor if you are not sure about what to invest in or don’t know how to pick stocks in general.