Nov 6, 2014 What you will learn from reading Chapter 4 of “Why Stocks Go Up and Down”
Chapter 4 is titled. “Ratios Investors Watch”
“When financial analysts first look at balance sheets or income statements, all they see is the same morass of numbers that the layman sees. To make sense of these figures, to evaluate a company’s financial strength or weakness, and to get insights into possible stock market performance, a financial analyst must look at the relationships between the figures. The ratios discussed in this chapter are among those frequently used by analysts.” This is an excerpt from the beginning of the chapter.
We cannot overstate the importance of understanding and being comfortable calculating these ratios for insights into the investment worthiness of a company. That said, not every ratio needs to be calculated, or is relevant for every company. For example, I am not worried about cash liquidity at Apple or MacDonalds. But for the most part, by understanding these ratios, and calculating them yourself, you will begin to see what they can tell you about a company. You will also quickly see which are not meaningful for a particular company or industry.
Comparing ratios of similar companies, or watching ratios improve or deteriorate over time for a single company, is one of an analysts most important tools. Seeing that Company X has a 5% Return on Capital, compared to 3% for an otherwise similar Company Y, begs the question as to why they are so different, what it reveals about the two companies, and what that difference may portend for each stock’s performance.
The ratios covered in the book can also be looked up on the internet, and there are some excellent descriptions there, often providing more detail than we do. We encourage interested readers to do this. In our book, we believe that we have provided enough discussion so readers will feel comfortable calculating and using the ratios, and will be well prepared when these ratios come back into the discussion in later chapters.
In sum, understanding and using key financial statement ratios is an important part of your investment education. It will add to your understanding of any company you are looking at, and to a greater or lesser degree, depending on the company, provide you with insights to a stock’s performance.
In Chapter 4, I particularly call your attention to the Earnings Per Share discussion at the beginning of the chapter. One of the most basic questions I get from students is why does a stock for sell for what it does? How does one know what the stock is “worth”? There are a number of commonly used theoretical models for calculating ” fair value”, or a range of fair value for a stock. We address it in one way that seems to help and stay with students. It may be thought of as a simplified version of the so-called dividend discount model. While this model is subject to mathematical description and analysis that can be found with an internet search, we cover it in a completely non-technical, but intuitive way. You do not need to be able to justify or provide the theoretical underpinnings, to understand it and be ready to move on.
Chapter 4 is long and at times arduous reading, but not every ratio has to be memorized before moving on.
Excerpts and comments about the other chapters will be posted over the next few weeks. If you want a preview of what is covered in the book immediately, please visit our website at www.whystocksgoupanddown.com and click on Contents.
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