Learning to invest is the best way to start with the basics. This article describes the four most common financial indicators, their meaning, and application.
1. Market capitalization
The size of the company does not depend on the price of its shares. In other words, if one company's share costs $100 and the other $30, it does not mean that the first one is more than three times larger than the second one.
A corporation may divide its shares, simultaneously increasing their number and reducing its price. For example, by splitting at a ratio of 2:1 securities worth $100, the company will receive twice as many shares, but at twice the price ($50). At the same time, neither investors' investments nor the company's size will change.
Then how can we measure the size of the company? Imagine a pie. No matter how many pieces you cut it into, the size of the pie will remain the same. The same applies to a corporation: the number of shares in circulation does not change the full market price. To calculate it, you have to multiply the number of shares by the current price. The resulting value will be market capitalization. The higher it is, the larger the corporation is.
For example, if a company has 5 billion shares in circulation worth $40, its market capitalization is $200 billion (5 billion * $40).
2. Net profit
Company results do not depend on its size. To evaluate them, investors need to know if the company brings in money. The net profit can tell us about this.
The calculation of net profit starts with the revenue — funds received by the company during the quarter or year. Revenue — money received from customers — is also called “sales” or “gross income”.
However, it does not give a complete picture: it is necessary to consider expenses. For example, an investor considers investment in a lemonade shop. He needs to know what kind of income this shop brings and what its expenses are. For example, if a year it was possible to sell lemonade for 1 million, and taxes, salaries, interest payments, raw materials took 1.5 million — such business can hardly be called attractive.
The remainder of the difference in revenue and expenses is called “net profit” or “net income”. It shows how much the company earns.
3. Earnings per share
Earnings per share (EPS) is a key profitability indicator. Its meaning is obvious: it shows what profit per share is in circulation. Usually, companies report on EPS value quarterly.
For example, the net profit of a corporation is 100 million dollars, and the average number of shares in circulation — 200 million. Then the profit per share equals $0.5.
The growth of EPS means that the company brings more and more income to its shareholders. It can invest it back in the business or pay out dividends. Earnings per share is an important factor in determining the internal value of the paper.
4. Price/earnings ratio
The main and most commonly used indicator in stock valuation is the price/earnings ratio (P/E). It helps investors understand how overpriced or underpriced each security is.
“Price” means the current value of a share. The “Earnings” can refer to either the company's current EPS for the twelve preceding months or the projected EPS. The former gives the investor a ratio based on real profit and the latter a forward P/E based on estimates of future profit. They can be used to compare a company's past and future (projected) results.
Imagine that the investor bought shares of two firms worth $10 and $20. If both made $1 per share, then in the first case he paid less for $1 profit than in the second. Just don't think that low value makes company securities “cheap”. If a share for $50 brings $40 profit to the investor and a share for $15 — only $3, then the first one is much better than the second one because its return on each invested dollar is much higher.
Keep in mind that the P/E ratio is a subjective value, which investors give to each paper. Earnings per share is a very specific and known number, but the price depends on supply and demand. A security's P/E ratio of 10 means that investors are willing to pay ten times more than their annual profit. The higher the P/E, the more investors expect to grow in the future.
Since P/E is based on investor perception, it can change a lot even for one company. The difference between the true value of a security and its ratio can be a good profit.
The main thing is to take the first step
Now you are familiar with some indicators used in stock valuation. But this is just the tip of the iceberg. There are many others, such as free cash flow, financial reporting and industry metrics to help you analyze different companies.
Most importantly, having gained an understanding of the basics, you are now ready to move to more sophisticated concepts from the investment world. Whenever you meet an obscure financial jargon, look for its explanation on the Internet. Gradually you will get used to it, and new concepts will no longer look so frightening. And articles like this will help you take the first step towards becoming a great investor.