In last week’s post on investing in stocks, I outlined how you could go through a company’s SEC statements such as the income statement and balance sheet to gain a better feel of its financial health- and also whether you should invest in its stock. I’ve also discussed how dividend stocks can help you attain a passive income.

However, there are many other quick and useful measures of a company’s financial health that you can take advantage of. These measures, also commonly called fundamentals, come in handy especially when you are comparing companies in the same industry or wondering if it’s time to sell a given stock. So, without further ado, here are some fundamentals to examine when you are evaluating a company stock:

EPS

EPS (earnings per share) was briefly mentioned last week as the net income a company generates divided by its number of shares. If the company also pays a dividend, that sum is subtracted from net income before that income is divided by share number. This is something to keep in mind when investing in companies that appear to have low reported EPS, such as the REIT stocks Armour Residential (ticker: ARR) or Resource Capital Corp. (ticker: RSO); many companies have a low EPS because they pay out a significant portion of their earnings as dividends.

In essence, EPS is a measure of a company’s profitability. Furthermore, EPS is not always a positive number; companies can post considerable earnings losses or no earnings whatsoever. More than anything else, a company’s reported EPS is a big event in the investment world; investors and analysts eagerly await the day that companies post their quarter or annual earnings in EPS. A reported EPS that beats estimates can cause a company stock to skyrocket; conversely, an EPS report that misses analysts’ estimates can result in a huge stock price drop.

P/E ratio

The P/E (price over earnings) ratio is a measure of a company’s stock price over its annual earnings per share. The P/E is used to judge the value of a stock in terms of how much investors are paying for it; for example, the current P/E of Amazon (ticker: AMZN) is a whopping 316, indicating that its valuation has gone sky-high and the stock currently trades at 316 times its annual earnings. Such high investor expectations for Amazon could easily be dashed, however, causing the stock price to plummet (i.e., undergo a correction).

On the other hand, Altria Group (ticker: MO) has a P/E of just over 15, meaning that it trades at 15 times its annual earnings. This stock is still valuable and is probably not overhyped by investors to the point of being prone to a correction. Incidentally, when a stock is touted as being undervalued or overvalued, the term is being applied to its low or high P/E, respectively.

The P/E is both an emotional and logical measure of a stock’s perceived worth and will vary by industry. Investors love sexy tech stocks like Amazon, which is one reason why its P/E is so high. On a more rational level, though, Amazon is also investing heavily into its business to become and stay #1 in the online marketplace. Investors who follow the company’s financial reports know that Amazon’s retained earnings are a big part of shareholder’s equity, a point I touched on in last week’s investment article. However, Amazon’s high P/E could easily fall if investors suddenly become spooked about the company or its management.

Alternately, because smoking has fallen out of favor with many people, Altria Group’s P/E is just over 15. However, the company makes solid earnings every year and even pays a sizeable dividend. Altria investors are thus less likely to become scared that the stock is overvalued and sell their holdings. This is also reflected in Altria’s low beta, the next stock parameter we will be studying.

Beta

The beta is a measure of a stock’s volatility relative to an index such as the S&P 500 over a period of time. It is a useful parameter to study if you are considering investing in a stock simply to gain its dividend (something I like to call dividend poaching) or are looking to invest in a stock for less than a year. Beta is also useful if you are wondering when you should invest in a particular stock in order to minimize risk and maximize return.

The beta is actually a slope of the stock’s trendline (Remember your high school algebra and y = mx +b? The beta is the m) and can range from negative to positive. If a stock’s beta is 1.0, that means that its price rises and falls in sync with the market’s. A stock beta of 1.4 indicates that this stock is 40% more volatile than the market while a beta of 0.5 indicates that the stock is 50% less volatile than the market. For example, if the stock of a company like Widgets-R-Us (ticker: WRU) has a beta of 1.2, that means that should the market gain 10% in a year, WRU will be up by 12% (or an additional 20% of that 10%). Should the market fall 20% in a year, WRU will fall 24% (or an additional 20% of that 20%).

Conversely, if the company has a beta of 0.5, its stock will fall only 50% compared to that of the market. Thus, should the market fall 20% in a year, WRU will fall by only 10% (or only 50% of 20%). There is a useful online tutorial if you really want to explore the concept and even calculate your own stock’s beta.

Beta is useful because it allows you to predict how a company stock will behave relative to the overall market. Predictability is good if you are risk-averse or need to time your trades in order to gain company dividends and then quickly sell to buy the next dividend-bearing stock (i.e., dividend poach). Likewise, let’s say you have some money to invest in the market but will need it in a year or less to buy a car or house (not recommended, by the way, but I’ve certainly done it). In such a case, you could invest your cash in a company stock that has a low beta, helping to ensure that you don’t lose your original sum- unless, of course, the entire market starts heading down. The criticism to this approach is that you probably shouldn’t invest money that you will need in a year or less.

D/E

The debt to equity ratio is another good measure of a company’s ability to successfully handle its finances. If you think of the company as a person you’re about to lend money to, would you want to lend money to a person who works a minimum wage job yet has massive credit card bills, two car payments, a  mortgage and is paying child support? Even if this individual has big plans for the future, would you trust that your loan will be repaid? A company should be similarly scrutinized.

The debt to equity ratio is calculated using the following formula:

D/E = Total Liabilities/Shareholder Equity

Total liabilities include business loans, mortgages and supplies- in essence, the total leverage potential of the company. This is divided by what the shareholders (as well as the company) have invested into the company. A company with a high D/E ratio may be rewarded by bigger earnings the following quarter or year; however, it may also stagnate under high interest payments and growing pains. A higher D/E ratio tends to raise the company’s beta too. Over time, you generally want to see this ratio decrease.

Incidentally, if you’ve ever obtained a loan, your personal D/E ratio was likely calculated by the lending institution or bank.

P/B ratio

The price to book ratio or P/B is, just like the P/E, another measure of a stock’s perceived worth. The formula for this ratio is the following:

P/B = Stock price/Book Equity (BE = Assets – Intangible Assets + Liabilities)

Assets are defined as cash, inventory, accounts receivable and equipment while liabilities are items such as loans, mortgages and accounts payable. Intangible assets are assets that are certainly valuable to the company but are harder to liquidate; examples include intellectual property, copyrights and trademarks. Thus, book equity is what would be left over if the company went bankrupt and had to liquidate.

A stock with a P/B ratio less than or equal to 3 might be a great bargain or it might have some fundamental issues. Because of this ambiguity, the P/B ratio should never be used as the only measure of a stock’s true value. Some reasons include the following:

1. The P/B ratio favors “old school” companies with a lot of assets.

2. Intangible assets are not accounted for or they are viewed as liabilities. This ignores many research, technology and service-based companies.

3. Events like acquisitions and share repurchases artificially deflate or inflate the P/B ratio, respectively.

Because P/B does not provide a complete picture of corporate health in and of itself, it should be paired with another parameter: the ROE.

ROE

Return on equity is defined as a company’s net income divided by its shareholders’ equity:

ROE = Net Income/Shareholders’ Equity

The ROE restates the EPS but on a hard, dollar-to-dollar basis instead of just dividing the company’s earnings by its number of shares (which can be increased or repurchased anyway). A company’s ROE and P/B should rise and fall with respect to each other- if they don’t, something is intrinsically wrong with the company. After all, a company with a high ROE should attract investors who bid a higher price on the stock. In some cases, though, a company might have a high P/B yet a low ROE. This indicates that company growth in terms of its stock price has not translated to improved company profitability. Without increased profits, shareholder value will stagnate. As such, this company would be a company to steer clear of.

ROI

The whole point of investing is for you to achieve an ROI or return on investment. The most basic ROI can be calculated using the following formula:

ROI = (Gain – Cost)/Cost

While the formula itself seems self-explanatory, remember that stock gains can include dividends, price appreciation or both. Alternately, you may have stock depreciation mixed in with dividends. Then there are the costs to consider, some of which include trading fees and taxes as well as your original investment sum. It’s important to track these numbers because you certainly want to see a return on your investment.

Also, the IRS taxes you at different levels on dividends as well as short and long-term capital gains. Rumors abound that dividends will soon be taxed as regular income. Capital gains taxes could increase from their current 15% maximum to 20% maximum for long-term investments. Meanwhile, short-term capital gains are being taxed at regular income tax levels.

Taxation of your hard-won stock trading profits is the biggest reason why holding onto stocks for at least one year (or longer) is recommended. Other recommendations for maximizing your ROI will be discussed >next week in my ongoing article series on how to successfully invest in stocks and make a passive income.

Photo credit provided by Florian Richter.

If you’re looking for ways to make some real money online, investing in stocks is still one of the best ways to do it. In spite of our lackluster economy, many companies are regularly churning out profits as well as dividends. Investing in these companies can be a great way to gain a piece of that corporate pie- provided you invest in the right pie.

Revenue, income and cash- oh my!

Back in June when I discussed how to make a passive income with stock dividends, I only lightly touched on studying financial reports before purchasing a company stock. However, analyzing a company’s financials is critical if you want to keep your investment dollars safe and not be surprised by a sudden stock price correction, earnings loss or bankruptcy (ahem, Enron). There are three financial reports that you will need to become familiar with: the income and cash flow statements and the balance sheet. There is also the statement of shareholders’ equity that is always worth a look-see. Finally, some companies make additional reports to the SEC via footnotes, which many investors fail to read but which can contain critical information about a company’s future.

Publically traded company financial statements are released on a quarterly or yearly basis as 10-Q or 10-K statements, respectively. Foreign companies provide their financial information on 20-F documents. You can find these documents by going on the company’s website and clicking on the Investor Relations link or tab. Alternately, you can find such information by going to the SEC’s Edgar website and typing in the name of the company.

The Income Statement

A company’s income statement answers two all-important questions:

How much money did the company make (i.e., total revenue)?

How much money did the company keep (i.e., net income)?

These questions are critical because they address a company’s growth and money-making potential as well as whether the business model is sustainable (i.e., profitable). After dividing net income by total revenue, you also get the profit margin, a key indicator of a company’s ability to survive and thrive even in a bad economy. Profit margin is also useful when comparing companies in similar industries; for example, in the grocery sector, where profit margins are historically very small, Whole Foods Market’s (Nasdaq: WFM) profit margin of 4.29% for the third quarter 2012 is better than that of Roundy’s (NYSE: RNDY), which stands at 1.91%. Dividing net income by the number of company shares also gives you another important factor: the earnings per share or EPS. The EPS will be discussed in the second part of my series on stock investment.

The Cash Flow Statement

A company’s cash flow statement answers another all-important question:

What is the company doing with its earned money?

The cash flow of a company might be going towards a debt repayment, expansion or outside investments. It might also just be getting stored as part of the company’s cash hoard. Classic examples of “cash hoarders” include Apple (reported at over $100 billion), Google (reported at about $45 billion) and Microsoft (reported at about $52 billion).

Cash flow can also be contrary to the real profitability of a business. Groupon (Nasdaq: GRPN), for example, reported its 2011 cash flow from operations as being $290 million; however, items that were not accounted for were $390 million in merchant accounts payable and $189 million in expenses and liabilities. When balanced out, this means that Groupon lost about $289 from running its business despite a positive cash flow.

The Balance Sheet

The company’s balance sheet answers the following questions:

How is the company doing right now?

Is the company better off today than last quarter/year?

The balance sheet provides such vital information as the company’s cash and cash equivalents, long-term debt, inventory, cost of goods sold (COGS), liabilities (e.g., mortgages) and accounts receivable (i.e., money owed to the company). The income and cash flow statements feed into and make the balance sheet, and many investors will actually look at the balance sheet first to gauge a company’s fiscal health.

The “balance” of the balance sheet comes from the following accounting equation, which must be satisfied in the balance sheet:

Assets = Liabilities + owner’s equity

In essence, a company’s assets must be equated by its liabilities, such as mortgages and business loans, plus any equity that the business owner brought into the business (e.g., building the business on land s/he already owned).

Looking at balance sheets across several quarters or years, you want to see an increase in assets and a decrease in debt. You also want to see a stable inventory, indicating that goods are not just languishing in some forgotten storehouse or on shelves. Likewise, inventory growth should not exceed sales growth. Inventory turnover rate, which is the number of times a business sells out its inventory in a year, can also be measured by taking the COGS and dividing it by inventory. The higher the turnover rate, the better.

Accounts receivable should also be examined as well as their rate of increase/decrease. As long as accounts receivable growth is keeping pace with sales growth, all is well. If, however, accounts receivable are increasing like crazy while sales stay the same or even languish, there could be trouble on the horizon.

Another useful number that you can obtain from the balance sheet is the quick ratio. The quick ratio is calculated by taking the company’s assets, subtracting inventory, and dividing the amount by liabilities. If the quick ratio is at least one or above, you have a good indicator of corporate fiscal health. A quick ratio of one means that, if the company were suddenly required by all its creditors to “pay up”, it would be able to do so by paying in cash and liquidating all of its assets. A quick ratio below one means that the company wouldn’t be able to immediately settle its debts.

Statement of Shareholders’ Equity

The Statement of Shareholders’ Equity answers the following question:

Where is shareholder money going and what has the company done with it?

Included as the last portion of the balance sheet, the statement of sharegolders’equity portrays the amount of financing that the company has enjoyed via its common and preferred stock offerings to investors. Shareholder equity is comprised of two monetary amounts: the original amount of money that shareholders used to buy equity in the company, along with later equity purchases and appreciation, and the company’s retained earnings from operations, which are defined as the earnings the company chose to reinvest in its operations versus using them for officer salaries, CEO bonus, etc.

Footnotes

Financial footnotes are arguably one of the best ways to find out what’s really going on at a company aside from being on its board of directors or spying on its officers (not advised, by the way). Footnotes answer all kinds of questions you wouldn’t initially think to ask, such as the following:

When does this company consider its good/service sold (i.e., how does this company account)?

Why are these operational/financial results significant?

Footnotes are kind of like the fine print of the financial reports that a company releases. In order to make those reports appear sleek and clean, many technical details are left out. However, because such details must be mentioned somewhere, they are often placed into the footnotes. Also, because it’s difficult to scour every single financial report for juicy company gossip, some websites such as Footnoted.com actually compile and report on company footnotes.

These footnotes tend to have either of the two characteristics:

They detail some accounting measure of the company. For example, a company may define when it considers a good or service to be sold and classified as revenue. Such an accounting definition is key for companies whose products are distributed through several channels before being sold to the end consumer; for example, Ford (NYSE: F) cars are manufactured at a factory, sold to dealerships, and finally sold to consumers. At which point is the car actually considered sold? For Ford, it’s at the point when the manufactured car is sold to the dealership.

They discuss why a financial or operational event bears significance. Companies often use footnotes to explain why a corporate officer was hired, why the company revised its income or cash flow statements, etc. Likewise, footnotes are often used to creatively hide bad events. For example, a company may have invested and lost a significant portion of its assets in a bad business deal. Because it is legally obligated to discuss significant events beyond just the legal minimum (e.g., income statement), this company could include the news of the bad business deal in its footnotes and then try to bury that news within a bunch of legal jargon. However, if you had read those footnotes, you would be instantly alerted of that bad deal. Furthermore, the company’s excessive use of “legalese” would’ve told you that something was amiss. This is just one more reason why it pays to read the “fine print”.

Hopefully, you’ve now gained a better understanding of company financial reports and how they can help you gauge the financial health and future of a company you’re thinking of investing in. Now that we’ve covered the three critical financial statements that companies release, next week’s article will focus on critical financial ratios like P/E, beta and debt/equity.