Saturday, February 20, 2010

Only 4 Ratios

if you could only have four ratios to evaluate a company what would they be? This is a fun question that is popular in investing circles. For a laugh I'll take my shot at it, what would you pick?

1) Current Ratio

Current Assets / Current Liabilities


This ratio keeps track of the company's ability to pay its short term debt. If a company doesn't have safety money to deal with debt then they might not be in business tomorrow and I don't need any of that.

2) Dividend Yield

Annual Dividend Per Share / Price Per Share


As a buy and hold investor I like to get paid to hold the investments. A nice yield makes for a little reward for patience.

3) Dividend Payout Ratio

Dividends/Net Income


Getting a great yield now is perfect, but how can you be sure that this dividend won't get canceled as soon as you buy the stock- you don't. One way of keeping an eye on this is to look at the payout ratio. If too much of the income is being eaten up with a dividend then beware that dividend might get cut or at least it sure isn't going to increase in the near future.

4) Dividend Growth Rate


If a company increases its dividend on a regular basis the returns over the long term can be jaw dropping. The future of a dividend can be more important than the present.

So how about you, if you only had four ratios what would you use?

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  1. I'd have:

    1. Price/Book - Lower P/B ratio stocks tend to give better results over 1-5 years.

    2. Gearing (net debt/equity) - Low gearing gives a company a better chance to survive whatever is causing it to have a low P/B.

    3. Current Ratio - For the same reasons you gave.

    4. Liquid ratio - Same as current ratio but allows you to ignore companies with valuable but illiquid stock.

  2. the same four i not only pick them i use them,thanks to what i learn from div-net

  3. If I could only pick four, I'd go with the following ( all of which would be calculated on the basis of 10 year historical averages ):

    1.FREE CASH FLOW MARGIN ( margin as a product of FCF/Sales ). I prefer companies that produce free cash flow at a rate of 10% of sales or more. FCFM demonstrates tangible outcome of sustained earnings and the possibility that a company has an "economic moat".

    2.DIVIDEND GROWTH. I prefer companies that have paid dividends without interruption for a minimum of 10 years and have raise dividends at an annual average rate of 10% or more. Demonstrates a commitment to shareholders and confirms sustainable earnings over course of the business cycle.

    3. DEBT/EQUITY. I prefer companies that are able to keep long term debt/equity at a level of 50% or less. Demonstrates that a company is able to operate without excessive leverage and that it may weather the storm of bear markets better than over-leveraged competitors.

    4. CYCLICALLY ADJUSTED PRICE/EARNINGS ( ie, current price divided by 10 year average earnings ). I prefer to take positions in companies when price is no greater than 16x cyclically adjusted earnings. This metric helps smooth out earnings over course of the business cycle and provide a modicum of assurance that one is not overpaying.


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