Understanding Stocks

FUNDAMENTAL ANALYSIS: TOOLS AND TACTICS 103
Price-to-Sales Ratio: Effective for Uncovering Revenue
Because P/E ratios are generally useless with companies that have no
earnings, some investors use the price-to-sales ratio (P/S) to decide
whether to buy a stock. The reasoning is that although you can play
with earnings, you can’t play with revenue. With the P/S ratio, you
compare price to sales revenue. To calculate the price-to-sales ratio,
you divide the company’s total market value by the total sales revenue
booked for the previous year. Some people claim that the P/S is more
reliable than the P/E or the PEG. (By the way, before Enron filed for
bankruptcy, its P/S ratio reportedly rose to over 200! Typically, a P/S of
over 5 is considered high, so 200 was a clear warning sign. It basically
meant that investors were paying $200 for each dollar of Enron’s sales.)
Many value investors will look for stocks with a P/S ratio of less than 1.
Return on Equity: Measuring the Financial Health of a Company
Return on equity (ROE) is a tool that helps you to measure how effectively
the company is being managed. Some people consider ROE one
of the most important measures of a company’s overall financial performance.
(You calculate ROE by dividing net income by net worth,
although this ratio is not as clear-cut because you must rely on subjective
variables to calculate manager efficiency.
In general, the higher the ROE, the more effective the company is
at using its resources and the more productive the management team. In
other words, ROE gives you an idea of how well the company is managed.
The goal is to look for companies with a rising ROE, greater than
15 percent and growing.
There are many other fundamental stock measurements, including
return on investment (ROI), debt-to-equity ratio, price-to-book ratio
(PB), and return on assets (ROA). The purpose of many of these fundamental
tools is to determine whether a stock is a good value compared
to its price. Because this is an introductory book, my review of fundamental
analysis ends here. For a more thorough examination of fundamental
analysis, you’ll find dozens of books about this topic at the
bookstore or public library.