A quick guide to financial ratio analysis, why you need them, how to read them and why you should not rely solely on the P/E ratio.

Financial ratio analysis provides a good picture of a company's profile, its financial condition, and where it stands in comparison to its closest peers. By analyzing a company's financial ratios, you can also undertake equity valuation using a simplified valuation model. I've already talked about this valuation type—you can read my article on stock target price calculation. Financial ratios also provide quick guidance on a company's financial performance and help you define the best stock among its closest peers. Unfortunately, some investment analysts and traders rely heavily on single ratio analysis when trying to find the best stock. I decided to write this article to explain why relying on a single ratio is a bad idea and also provide quick guidance on how to undertake express company analysis using the most valuable financial ratios.

Why is relying on a single ratio a bad idea?

I've seen a lot of articles and people mentioning the P/E ratio when talking about equity fair valuation or when trying to rationalize their stock selection or trading decisions. While the P/E ratio provides a somewhat good picture of a company, especially when comparing to industry averages and closest peers, this ratio itself does not provide the complete picture. Moreover, in the current stock market setting, where larger players are taking hold positions and the market is flooded with speculative capital, the P/E ratio will be extremely fluctuating, providing misinformation. Some larger companies' stocks like NVDA or TSLA, for example, are very volatile now, making the P/E too volatile. If you base your stock selection purely on this ratio, you may find yourself in trouble very soon. I always tell my stock market class students that this ratio should be used together with other vital ratios when evaluating a company. Now let's consider what are some other valuable ratios that you should employ in your investment analysis.

WACC/ROIC ratio as a great partner to P/E.

WACC stands for the weighted average cost of capital. In simple words, it's the average weighted cost of a company's attracted funding. As you may know, the company has two major sources of funding: equity (own funds) and debt (attracted funds). Debt includes borrowed money (from the bank, for example) and fixed income issues (bonds), while equity includes retained earnings, reserves, and stocks that the company issues. When the company attracts debt, it incurs interest expenses, whereas with equity funding, the cost of equity arises. When analysts calculate WACC, they take into consideration the equity and debt weight in the company's balance sheet structure, as well as the cost of equity and debt. Now let's talk about ROIC.

ROIC, on the other hand, stands for Return On Invested Capital. In simple words, it is the return that the company is making from attracting funding, both equity and debt. Its calculated as Net Operating Profit After Tax (NOPAT) divided by Debt + Equity and other long term funding sources. This ratio provides a good picture of how the company is using its funds. If investment analysts or traders see that a company's ROIC exceeds its WACC, it means that the company is making profits from its attracted funds. To gauge the company's efficiency in using its funds, investment analysts calculate the ROIC/WACC ratio.

How to use the ROIC/WACC ratio together with P/E?

When the ratio is greater than 1, it means that the company is generating positive returns on its attracted funds. When the ratio is smaller than 1, it means that the company's costs exceed its returns on attracted capital. Analysts should also compare this ratio to the closest peers and choose the company with the highest ROIC/WACC ratio. Ideally, the P/E ratio should be close to the industry average. This would indicate that the company is generating the highest return on its attracted funds among its closest peers and traders haven't spotted this great investment idea yet. If the P/E ratio is higher than that of its closest peers and industry average, you should prioritize the ROIC/WACC ratio. In the current highly volatile stock market, the P/E ratio alone won't give you a good signal, and low investor confidence combined with high trader expectations makes it a poor indicator for assessing a company's attractiveness.

UFCF to CapEx for assessing a company's efficiency in using operating cash flow.

UFCF (Unlevered Free Cash Flow) is calculated as operating cash flow (or EBIT*(1 - tax rate)) plus depreciation and amortization, minus capital expenditures (CapEx). Operating cash flow is the cash flow that the company generates from its main activities. If this number is positive, it means that the company is making profits from its main activities. If operating cash flow is negative, it means that the company is experiencing cash outflow from its main operations. By calculating UFCF, you are trying to determine the amount of cash that the company has from its main activity after deducting capital expenditures. In simple words, the UFCF to CapEx ratio tells you how much free cash flow the company generates for every dollar spent on capital expenditures. It helps you gauge how efficiently a company is using its investments in long-term assets to generate free cash flow.

Now let's consider how to use the UFCF to CapEx ratio.

Its application is similar to the ROIC/WACC ratio: find the company with the highest ratio and also pay attention to how this number changes from quarter to quarter. A highly volatile ratio (from quarter to quarter) is a bad sign because it indicates that management is not controlling the company's capital expenditures well, or perhaps the company's operating cash flow is not stable. This is also problematic, as higher cash flow instability creates lower accuracy when forecasting the stock's fair value.

Use company-specific ratios to better assess its risks.

The ratios mentioned above are great, but they don't highlight company-specific risks. When undertaking equity valuation using a simple financial ratio valuation model, you should use a combination of standard valuable ratios mentioned above and company-specific ratios. For example, if a company is operating in the oil and gas industry, you should take into consideration the ratio of proven reserves to its revenue. A higher ratio indicates that the company has substantial proven reserves relative to its current revenue. This suggests that the company has enough reserves to continue producing and generating revenue for a long period, making it more sustainable in the long run. When you use ratios customized to the company's business, you can react quickly to industry changes and better forecast how different industry shifts may affect your selected company.

Where should I get these ratios when analyzing a company?

For calculating the ROIC/WACC ratio:

- ROIC can be accessed from FMP's key metrics API endpoint.

- WACC can be accessed from FMP's advanced DCF API endpoint.

- The P/E ratio can be found in FMP's ratios API endpoint.

To calculate UFCF to CapEx:

- You can extract operating cash flow, depreciation and amortization and capital expenditures from FMP's cash flow statement API endpoint. And the effective tax rate from the ratios API endpoint.

For custom financial ratios:

- You can go to the financial statements, read the auditor's report, and examine the company's business closely. Undertake balance sheet and income statement vertical analysis to understand what is the largest item, then make your custom ratio based on this largest item that your selected company relies on.

I hope this guidance was useful to you. Now you know how to evaluate your selected company correctly, how to undertake equity valuation, and how to read financial ratios properly to find the best stock among its closest peers. I hope this article was useful. Please reshare it if you liked it to help spread the knowledge.