🎙 In part 2 of this series, we’re looking at some of the key ratios you need to be aware of when you’re learning how to pick stocks. We’ll focus on some of the key profitability and valuation ratios like EPS, P/E ratio and return on equity. These help investors determine whether or not a company is a good investment choice for their investing strategy. 🤔
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Hey there, friends! And welcome back to Girl on FIRE, the financial independence podcast for independent women.
My name is Priya, I’m a Chartered Accountant, an analyst and the creator of Paper Money Co.
I’m also a fierce financial feminist and the host of this podcast. I believe that a woman who is in control of her money, is in control of her life.
Today, we’re continuing on with part 2 of our 4-part series talking about how to pick individual stocks to invest in.
Last week, we talked about what financial statements are and how they’re prepared. So, if you missed that one, definitely go back to episode 32 before you continue.
Because in this weeks’ episode, we’re going to talk about actually analysing those financial statements to understand how financially healthy a company is.
This is a super important step when choosing which individual companies to invest in. Because you want to make sure that you’re making a sound investing decision.
You don’t want to invest your hard earned money in a company that can’t give you any return on your investment.
So, you need to analyse a company’s finances to understand how it’s operating and how it’s performing so that you can make the best decision for you and your investing strategy.
So, that’s what we’re talking about today. And a bit later on in this episode I have some really big news to share with you and a little personal update too.
But before we get started, I want to remind you to head to my website — papermoneyco.com/startinvesting to download your free copy of my Investing Starter guide
It’s totally free, you just need to enter in your email address and I’ll send it straight to your inbox.
It gives you a step by step plan to follow to get your finances ready to start investing, including working with a budget, building an emergency fund and paying off debt.
The sooner you can get your foundation set and get those good money management practices in place, the sooner you can start investing and building your wealth.
If you’re really serious about learning to master your money, then it’s the perfect guide for you, and I’d hate for you to miss out on it.
As always, Girl on FIRE is about learning, so whip out your favourite notebook or journal and get ready to take some notes.
If you’re not into writing things out by hand, you can always find the transcript on my website — papermoneyco.com/gof33.
Okay, let’s dive in!
Financial statement and analysis
So, in this episode, I want to focus on calculating and understanding a few of the key financial statement ratios.
There are 5 main categories of ratios you can use to analyse a company’s finances.
There are profitability ratios which determine how much money a company makes and how operates and how it distributes that cash to reward investors.
Then there are liquidity ratios which measures how quickly a company can pay its’ debts.
Next, there are solvency ratios which we use to figure out whether a company is able to pay its’ debts.
We’ve also got efficiency ratios which indicate how well a company uses its’ assets to generate income. Essentially, how efficiently they operate.
And lastly there valuation ratios which help us in determine a company’s value as an investment option.
This topic will be split into two episodes because I can’t sit around talking to myself for too long. So, this week, we’ll look at valuation and profitability ratios.
And next week, we’ll look at solvency, liquidity and efficiency ratios. Those are a bit more complicated and a bit less common.
Ratios add context to a company’s finances
Now, there are a couple of things I want to address before we look at specific ratios. Firstly, why bother? Why do we need to put in the time and effort to calculate and understand these ratios?
Why isn’t it enough to just see from the income statement that the company is making a profit and call it a day?
And the answer is: context. These ratios provide more context than simple figures in a company’s financial statement.
For example, you might see that a company made $1bn of profit, but they generated that income from $100bn of assets. Which means their shareholders are earning a 1% return.
So, the ratios add a bit of context and help you judge a company’s finances from multiple different angles.
Ratios & benchmarks change depending on industry and location
Now, another key thing to note is that ratios will change from company to company but they’ll also change from industry to industry.
And any ratio benchmarks as to what’s good and what’s not will also change from industry to industry
Not only that, but ratios and benchmarks will change from one geographic region to another as well.
And this is something we talked about last week in episode 32. We talked about how company’s have to follow rules and guidelines which dictate what their financial reports look like.
And those rules and guidelines look different depending on where a company lives.
So, if you’re comparing ratios for an American company against an Australian company or a French company, those ratios will all look a little different.
So, those are some key things you need to keep in mind when analysing company finances.
Okay, let’s look at some ratios. To kick things off. I want to talk about some key valuation ratios first, because I’m sure, if you’ve ever tried researching any stocks, you’ve seen this before.
Earnings Per Share (EPS)
First up, the EPS or earnings per share. This indicates how profitable a company is by allocating it’s net profit to each of it’s outstanding shares.
Essentially, how much profit a company generates relative to how many shares it has issued.
To calculate the EPS you need to take the net profit, minus any preferred dividends which have priority over regular dividends, and divide it by the number of common shares that are outstanding.
So, for example, let’s look at Commonwealth Bank or CBA, one of the biggest companies on the ASX which is the Australian Stock Exchange.
CBA’s earnings per share is 3.62. Now, this is an example of a ratio I didn’t have to calculate myself.
I just logged in to my brokerage tab, searched CBA and looked at the information that was already available.
But an EPS of 3.62 means that each share is earning $3.62. Now, the higher a company’s EPS is, the more profitable it’s considered to be.
And that’s because a higher EPS indicates a higher value because investors will pay more if they think a company has higher profits relative to it’s share price.
So, if we take that a step further, CBA has an EPS of $3.62 but it’s share price is $99.30.
So, as a new investor, you might purchase CBA stock at a share price of $99.30 and each share is only generating $3.62 of net profit.
Price / Earnings Ratio (P/E ratio)
And that brings me to the next ratio, the price / earnings ratio or the P/E ratio.
The P/E ratio measures a company’s current share price relative to it’s earnings per share, it’s EPS. It’s calculated by taking the market value per share, which is the stock price, and dividing it by the EPS which we just talked about.
So, for CBA, it’s current share price is $99.30 and each share is earning $3.62. That means it’s P/E ratio is 27.43. And again, this information was available in my brokerage account, I didn’t have to calculate it.
But a high P/E ratio could indicate that a stock is overvalued. Because the share price is so much higher than the net profit that’s allocated to each share.
Or, it could also indicate that investors are expecting this company to experience high growth in the future. They’re not earning a ton of net profit now, so the EPS is kind of low.
But they’re expecting good growth coming up, which makes them a more valuable investment and drives up the share price.
Now, looking at these two ratios is a good way of comparing one company against each other when you’re deciding where to invest your money.
You’re not just looking at profitability or earnings in isolation, you’re looking at it compared to how many shares have been issued and what the current market price of those shares are.
It’s a way to help investors determine if a company’s stock is overvalued or not. Because if an investor thinks a stock is overvalued, they’re not going to buy it.
When that stock price corrects itself, they’ll be making a capital loss.
But it’s super important to remember that these ratios will look different across different industries.
For example, the EPS of a big bank is going to look different to the EPS of a mining company or a tech company or a real estate investment company.
Okay, let’s look at some profitability ratios. First up we have the gross profit margin.
This shows you how much of a company’s income is left over after all the costs of goods sold have been paid.
Cost of goods sold vs total expenses
Now, it’s important to remember here that cost of goods sold is not the same as all your expenses. It’s referring only to the cost of what you sold, not all the costs you incurred to sell it.
For example, let’s say you’re running a lemonade stand. You need lemons, water, sugar and ice.
You ask your customers to bring their own bottles and glasses because you’re running an environmentally friendly business here.
You put up posters around the neighbourhood advertising your lemonade stand.
And you paid your little sister a few dollars to walk around to the neighbours and ask them if they want some lemonade.
Now, when it comes to your cost of goods sold, you’re only looking at the cost of the lemonade — the lemons, the water, the sugar, the ice.
You’re not looking at the cost of the posters or what you paid your little sister.
Let’s look at another business. There’s an independent book store in town. They buy books and sell them.
The cost of buying the books is the cost of goods sold. But the cost of running the shop, the electricity, paying the employees, putting ads online, renting the space — none of that counts here.
So, it’s super important to remember that distinction between cost of goods sold and total expenses.
Because your gross profit margin is only how much income you’ve got leftover after you’ve paid for your cost of goods sold.
It’s not a company’s final profit. It only shows how much profit a company makes on their goods and services before they pay all administrative and operating costs.
Gross profit margin
Now, the gross profit margin is calculated by taking the gross profit which you should see on a company’s income statement. And dividing it by the total sales.
It’s a measure of how profitable those goods and service are as opposed to how profitable the company as a whole is. Think of it like the mark up on something.
So, if we return to our bookstore example for a second, let’s say that the gross profit margin is 10%.
That means the company bought a book and then sold it for a price that was 10% higher than what they paid for it. So, the higher the gross profit margin is, the better.
Now, if you have a negative gross profit margin, you’re in trouble. It means you’re not even recovering the cost of the product let alone being able to pay your employees or anything like that.
When a business is still in it’s start up phase, they still have to pay the rent, keep the lights on and pay their employees.
And because they’re a new business, they may not be earning enough income to do all of that and still turn a profit.
That’s normal. But if what you’re selling isn’t even profitable in the first place, then you’ve got bigger problems.
It could indicate that there isn’t enough demand for what the company is selling. Or maybe they’re selling something so expensive that it isn’t a viable business.
FIRE & investment calculator spreadsheet
Before we move on, I want to ask my Girls on FIRE for a favour. If you’ve listened this far into the episode then you’re probably enjoying it, right?
So, here’s what I’d like you to do next. Pause this episode for a few seconds and head on over to papermoneyco.com/podcastreview.
I want you to leave a rating and review for Girl on FIRE because it helps me provide better content based on what you’re enjoying the most.
It helps other women out in the internet wilderness come and find us as well.
And it’s also a great way to support this show for free, and for that I’d love to send you a little something to say thank you.
So, once you’ve done that, take a screenshot of your submitted review and email it to me at email@example.com.
If you do that, I’ll send you a copy of my FIRE and investment calculator. Which, if I do say so myself, is pretty damn amazing.
It’s how I plan for my early retirement and my wealth. It shows me how my wealth is going to grow, when I can retire and how long my money will last.
And it also has a separate tab that takes Australia’s superannuation into account as well.
And you can use it to analyse companies and different investment options when you’re picking stocks too.
I’ve never actually seen anything like it before, so it’s pretty special. And I’m currently not offering that spreadsheet anywhere else except for Camp FIRE members.
Not in my shop, not to my email list — it’s a ghost. So, this is kind of a money-can’t-buy type deal.
The only way to get your hot little hands on that spreadsheet is by submitting a rating and a review, taking a screenshot and tagging me in it.
That URL again is papermoneyco.com/podcastreview. I’ve made it nice and easy for you.
So, go hit pause and do that right now. It’s okay, I’ll wait.
Okay, that concludes my little ad-break, so let’s get back to it.
Net profit ratio
Now, after your gross profit, you have your net profit. This is the company’s final profit number after they’ve paid all their expenses.
So, not just the cost of the making the lemonade, but also the cost of the posters and your little door to door salesperson.
The net profit margin is calculated by taking the net profit after taxes and dividing it by total sales, and again, those figures will be on the income statement.
This shows overall, after all income and expenses have been taken into account, how profitable a company is. So, the higher the net profit margin is, the more profitable the company is.
A net profit margin is showing the net profit relative to how much income a company earned. So for a net profit of 30% which would be out-of-this-world phenomenal.
It means that from all the income the company earned, they’ve paid all their expenses and they’re making an overall profit of 30%.
Now, that 30% profit is either going to be reinvested back into the business or it’s going to be distributed to shareholders as a dividend.
Return on equity
Next, let’s look at the return on equity ratio. This is calculated by taking the net profit and dividing it by the average shareholders’ equity.
Now, shareholders’ equity is how much money investors have invested in a company.
So, the return on equity is showing you how much net profit a company has generated relative to the amount that has been invested in the company by shareholders.
Essentially, how much net profit a company is generating for each dollar shareholders have invested.
Now, it’s important to note here that this isn’t necessarily the same as the return you’re making on your investment.
Because your return on investment takes capital gains from share price movements and dividends into account.
It’s not directly based on a company’s net profit. Yes, when a company is profitable, its’ share price can go up and you can earn a capital gain.
But that’s not the same thing as a company’s return on equity. Because we know that all sorts of things impact share price, not just the profitability of the company.
Share prices are very heavily impacted by investor sentiment and speculation which we talked about in episode 27.
Okay, so when it comes to return on equity, the higher the better. A higher return on equity means that a company is generating more and more profit using shareholders money.
For example, company A could have a return on equity of 2% and company B could have a return on equity of 10%.
Company B is more profitable in this scenario because each dollar that shareholders have invested is generating more profit than company A.
Return on assets
Following on from that, the last ratio I wanted to talk about today is the return on assets. It’s very similar to the return on equity.
But instead of looking at how much net profit a company is able to generate from its’ shareholders money, we’re looking at how much net profit it can generate from its’ assets.
So, the return on assets is calculated by taking the net profit and dividing it by the average total assets a company has on their balance sheet.
And again, the higher it is, the more profitable that company is because they’re generating a higher profit for each dollar of assets they have.
Big news & personal update
Before I sign off for this episode, I wanted to get really personal for a minute and share something with you.
Enrolment for my first online course Financial Mess to Money Success closed a few weeks ago.
And I know that some people missed out and they’ve joined a waiting list so that I can email them when enrolment re-opens.
But I wanted to take a moment here to be really honest with you and be super transparent about what’s going on, what’s changing and why it’s changing.
I’ve decided that I won’t be re-launching Financial Mess to Money Success again, at least not in that way. There are a number of reasons behind this decision.
And I did quite a bit of soul searching in deciding what the new era of Paper Money Co and Girl on FIRE looks like.
Now, rest assured that at this moment I have absolutely no plans to stop making this podcast or running Paper Money Co.
But I did want to be transparent with you about why I won’t be re-launching courses in the same way in the future and what will be happening instead.
Firstly, I stand by the content in FMMS 100%. I put a lot of work and a lot of myself in teaching my students the exact system they needed to create a solid financial foundation.
But there was one key ingredient missing. It was too impersonal. I didn’t like the idea of having a series of pre-recorded lessons for students to consume on their own.
I want to create a more immersive and engaging experience instead, and a course like that isn’t the right platform. So, that’s the first reason.
The second reason is that I absolutely hated having to host a sales pitch disguised as a masterclass. I felt disgusting doing it, it made me really uncomfortable.
I felt like a sell out and I hated it. It’s the popular advice on how to launch an online course but it’s not me.
I want everything I do and everything I create for you to be super worth your time and super worth your money. And a masterclass like that wasn’t good enough, so I won’t be following that format again.
Another reason why I won’t be launching courses like that again is that it’s honestly a lot of work. It’s an incredible amount of work and all that work needs to be done upfront.
I can’t create the course content week to week because I also have a full time job and life happens.
And on top of researching, writing, recording, editing and publishing a new episode of Girl on FIRE every week, it’s too much.
Everything I do here on this podcast is completely out of my own pocket. You may have noticed, there are no sponsor segments on this show.
Not in a single episode. There are no ads in my weekly newsletter or on my website. None of my social posts are sponsored or affiliated with anyone other than myself.
I’ve been approached by a lot of companies looking for sponsorship opportunities over the past few months as the podcast has really grown.
But I’ve rejected them all because I’m not interested in selling something that I don’t believe in.
And yes, those opportunities do make the financial side of running a website and podcast easier. It does cost a fair amount of money for me to do what I do, but I pay for it out of pocket because I think you and this community deserve better than to listen to random and meaningless ads.
I have high standards for everything I create and also for my integrity. Which is why I hated having to do a masterclass the way that I did.
Your trust is way too valuable to me. This isn’t just some podcast about beauty tips or reviewing movies.
We’re talking about life and money and those are huge things that take a lot of trust. So I’m not taking advantage of it to make a few bucks.
With all costs being paid out of my own pocket, though, it means I also don’t pay myself for anything that I create.
All income goes right back into Paper Money Co. That means I’m working a second full time job and not paying myself a penny for it.
This show is also professionally produced and edited. But it’s done by my husband in his own time, and I’m not paying him for it either.
So, launching another course like that with all that work upfront is just not possible. Not in terms of time or in terms of being able to support ourselves for what we create.
So, with all of that, I’ve got a HUGE announcement to share on what the new era of Paper Money Co and Girl on FIRE looks like.
I want to introduce you to my brand new membership experience: Camp FIRE! I’m so freaking excited about it. And trust me, that’s not the “F” word Potty Mouth Priya wanted to use there.
It’s a collaborative, community based membership experience that’s focused on building wealth and building a life that you love. So, we’ll be talking about all things money and all things creating a life you love.
It’s a place where like minded women from all walks of life can learn, grow, support each other, seek guidance and encouragement for taking control of their finances and their lives.
Camp FIRE is currently scheduled to launch on September 1st. There’ll be weekly livestream masterclasses where I teach not only theory but by example from my own numbers and all my own spreadsheets.
And these masterclasses will be like these podcast episodes. Full of value and insight, not some glorified sales pitch like a lot of other masterclasses on the internet.
I’ve mentioned this before, but that’s not something I’m willing to share openly to the public on YouTube, because I’m not interested in attracting trolls with their petty, useless BS into my life.
And I don’t want that for you either. Camp FIRE is a place where we can gather around a campfire together and share our goals and our stories and empower each other. Without all that negativity on the internet.
I’ve gotten emails from a number of you telling me how you’ve been treated on social media when asking for advice, and what I really want is to create a safe place where that’s not going to happen.
You’ll also be getting all the tools, spreadsheets and resources I create, and you’ll be getting all the upgrades for those tools as a member as well. And of course, I’ll be teaching you how to use them all too.
And Camp FIRE won’t be just about the money side of financial independence and freedom.
It’ll also be about building the life of your dreams. Because, as I say in every episode, a woman who is in control of her money is in control of her life. So, we’re going to grab that bull by both horns in Camp FIRE.
We’ll also have livestream backstage discussions about our weekly podcast episodes, fortnightly community hangouts, there’ll be a monthly book club focused on sharing the experiences of women.
And that’s just what I’m planning for now. After launch I’ll also be launching a vlog so you can see what all of this looks like in real life, behind the numbers and the spreadsheets.
I also want to add office hours where you can share your spreadsheets and get advice on your numbers from me and from our community.
I want to give you an incredible, premium 5-star membership experience, one that completely blows your mind. One that’s based on collaboration and community and friendship between like minded women.
But I also want this to be as affordable as possible, which is why monthly membership fees for Camp FIRE will be only $10 a month.
And that’s in Australian dollars, so for my Campers in the US, it’ll be about $7 or $8 a month. But there’s also a bit of a discount if you choose to pay annually.
So, less than the cost of a latte every week, you’re going to be getting an insane amount of value.
I’ll have a lot more details coming up for you in the next few episodes. But I’m super excited about this. And I really hope you are too.
So, I just wanted to take this time to share with you what changes are coming and why they’re coming.
I’ll definitely be sharing more details about Camp FIRE in coming episodes and through my free newsletter which you can sign up for at papermoneyco.com/startinvesting.
Thank you for giving me the space to be really honest and transparent about all this and for sharing this with you.
Next weeks’ episode
And that’s all I have for you Girls on FIRE today!
My challenge for you this week is to head to the stock exchange website, pick a company and take a look at their EPS and P/E ratios.
Pick a few companies in the same industry and compare those ratios. Do you see any companies that might be overvalued?
On next weeks’ episode we’re going to continue looking at financial statement analysis and ratios.
We’ll look at how you can determine if a company is able to pay off its’ debts and whether business is running smoothly or not.
It’s going to be a super interesting episode so you’re definitely not going to want to miss it.