This series of posts comprise of the key things learned while reading Warren Buffett’s Three Favorite Books by Preston George Pysh. This post will list all the important stock metrics used to measure how company is doing. All the information is available in either Balance Sheet or Income Statement of the company, so we will start with them.
Balance Sheet
Balance Sheet answers the question of how much the company is worth as of that time.
It comprises of Total Assets (what company owns) and Total Liabilities (what company owes). If the company was a person, assets will be things like house and car, and liabilities will be something like mortgage and student loan. The worth of the company equals the difference of assets and liabilities (i.e. assets - liabilities). This is called Shareholder’s Equity or Book Value. Shareholder’s equity can be negative when liabilities exceed assets. Current Assets are assets that are expected to convert to cash within next 12 months and similarly Current Liabilities are liabilities that will come due within next 12 months.
Income Statement
Income Statement answers the question of how much money the company made during that period.
Net Income is the remaining profit left after subtracting all expenses and taxes. For a person, this would be money earned (ex. paycheck) minus all expenses (ex. rent, groceries, etc). Another name for net income is earnings. You will also find the number of shares outstanding on Income Statement. If there’s diluted number, you want to use that one because it includes shares given as compensation.
Key Metrics
Book Value Per Share:
Book Value is equivalent to Shareholder’s Equity on Balance Sheet. Divide the book value by the number of shares outstanding and you will get this number. If the company is to go out of business, this is what the company is worth. The book suggests book value growth rate to be at least 7% year over year, and if this is not the case, compensated by larger dividends (above 2%).
Earnings Per Share:
Earnings Per Share (EPS) is Net Income on the Income Statement divided by the number of shares outstanding. EPS signifies how much money your share will make every year.
Return on Equity (ROE):
Return on Equity is Net Income divided by Shareholder’s Equity. This metric answers the question of how efficient the company is employing the capital at hand. The book suggests buying company which has ROE consistently above 10%.
Current Ratio:
Current Ratio equals Current Assets divided by Current Liabilities. We definitely want current ratio to be above 1 otherwise company will lose money in the short term, and this book recommends current ratio higher than 1.5. If current ratio is less than 1, the company might have to incur more debt to make ends meet.
Debt/Equity Ratio:
Debt/Equity Ratio equals Total Liabilities divided by Shareholder’s Equity. This metric tells you how much debt company has incurred compared to Shareholder’s Equity. The good number suggested by the book is Debt/Equity Ratio less than 0.5.
Price/Book Value (P/BV):
Price/Book Value is Stock Price divided by Book Value. This signifies the premium investors are willing to pay over the book value. This book suggests good price/book value ratio lies between 0.6 and 1.5.
P/E:
P/E refers to Price to Earnings Ratio and is calculated by dividing the current stock price by Net Income. For stock with 20 P/E ratio, you can interpret this to mean that for every $20 you invest, you can expect $1 in earnings next year. The book suggests buying companies with P/E ratio lower than 15.
* Note: These metrics can return absurdly big number when the denominator is really small or become meaningless when the denominator is negative. The good thing is when either one of these happens, any ratio mentioned above will not be within the suggested range. This will hopefully dissuade most from investing in that specific company.