How to Choose the WinnersUnderstanding Penny Stocks

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Leeds Analysis IV - Fundamentals

Improving Financial Ratios

While it is useful to know the price of a stock and the earnings of a company, combining the two into the financial ratio known as Price to Earnings, or P/E, can be even more useful.

You can then compare companies to each other directly, and also get an idea of the earnings power you are gaining for each dollar you put into the stock.

You see, with P/E you can compare 20 different stocks on an even footing. It eliminates the differences in shares outstanding and trading price. You are left with a single number that can be meaningfully compared to the rest.

For example, an analysis of six companies could yield you P/E results of 5.5, 5.8, 6.9, 12.2, 19.8, and 201.0. As lower P/E ratios are better (meaning that you pay less share price for each dollar of earnings power), it would stand to reason that the company with a 5.5 P/E is best from that perspective, while the one with the huge 201.0 result is greatly anomalous to the rest of the companies you screened.

As well, if you see that the P/E ratio (or other financial ratios you use) are improving from one quarter to the next, it should be an encouraging sign.

Personally, I never pick a stock based on financial ratios, but I eliminate them at the drop of a hat if their ratios seem out of whack. If I like a company, strong ratios will reinforce my decision. However, I highly prefer to look at the hard numbers: I like earnings per share (which technically is a financial ratio) more than the P/E ratio, I like looking at total debt more than debt/equity.

Other financial ratios you might want to employ include Debt to Equity, Price to Book Value, or revenues per share, and there are dozens of others.

Note! If you find financial ratios confusing or time-consuming to calculate, do not dispair. With highly speculative penny stocks, financial ratios are less important than they are with more conventional equities. They are a piece of the puzzle, rather than a major driving force.

There is a section in the Bonus Chapter of Understanding Penny Stocks, which introduces you to financial statements. As well, there are dozens of free websites that will go into much more detail than I will offer here, if you feel you need help with this aspect.

Financial Ratio Cheatsheet

All of the following ratios can be calculated using numbers available in the company's financial statements.

Current Ratio = Current Assets / Current Liabilities

A company's ability to meet its debts and obligations. A strong company should have a current ratio of 2.0 or higher.

Quick Ratio = Current Assets Inventories / Current Liabilities

A company's ability to meet its short-term debt, with liquid capital and easily accessible assets. Most comanies should have a quick ratio of 1.0 or higher.

Return on Assets = Net Income / Average Total Assets

This number tells you how effective a business has been at putting its assets to work. The ROA is a test of capital utilization - how much profit (before interest and income tax) a business earned on the total capital used to make that profit.

Return on Equity = Net Income / Stockholders' Equity

The income a company brought in, compared to the company's 'value' to shareholders.

Profit Margin = Net Income / Total Sales

The gross profit margin ratio indicates how efficiently a business is using its materials and labor in the production process. It shows the percentage of net sales remaining after subtracting cost of goods sold. A high gross profit margin indicates that a business can make a reasonable profit on sales, as long as it keeps overhead costs in control.

Inventory Turnover = Cost of Goods Sold / Average Inventories

This ratio tells how often a business' inventory turns over during the course of the year. Because inventories are the least liquid form of asset, a high inventory turnover ratio is generally positive.

Debt to Equity = Total Liabilities / Total Stockholders' Equity

This ratio indicates how much the company is leveraged (in debt) by comparing what is owed to what is owned. A high debt to equity ratio could indicate that the company may be over-leveraged, and should look for ways to reduce its debt.

Besides the select list included above, there are literally dozens more financial ratios. Each has its own place and application. If you are interested in learning more about financial ratios, although their effectiveness is somewhat limited in terms of speculative penny stocks, there are many sources both online and offline.

What is a good sign: Having a lower P/E and Debt/Equity ratio than other companies in the same industry. Improving trends in the financial ratios from one quarter to the next.

What is a bad sign: If one of the financial ratios is far out of whack, it could send the whole company toppling. If you find a debt/equity ratio that is above 2.0, and is far higher than the other penny stocks in the same sector, it may be cause for alarm.

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