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a low Debt/Equity ratio is a good thing. In fact, you’ll find many companies that have a Debt/Equity ratio of zero. At the same time, you’ll find numerous companies that have a Debt/Equity ratio of 5 or higher. For a company that has a Debt/Equity ratio of 5, that means it’s got 5 times more debt than it has equity in the business.
(As a general rule of thumb, I try to always buy companies that have a Debt/Equity ratio below 0.50)
Current Ratio: This ratio is a comparison of the current assets divided by the current liabilities. I find this ratio very important because it tells me if the business will need to take on debt in the next twelve months.
Current Ratio = Current Assets / Current Liabilities As you put hypothetical numbers into this equation, you’ll quickly see that a 1.0 means the company won’t owe or earn capital. As the number becomes larger, it becomes evident that the company has an easier time paying its liabilities and won’t need to issue more debt. When I’m analyzing a business, I’ll never consider a business that has a current ratio below a 1.0.
So, when we take the company’s total equity and divide by the total number of shares outstanding, we get the book value (or equity per share).
As we look at the book value above, this number often serves as a reference point – a keystone, if you will. We know that if the company ended today (liquidated), it should be worth the amount of book value.
Benjamin Graham really tried to avoid buying companies that traded at a multiple higher than 1.5 times the book value. As
Shares Outstanding: This is simply the total number of shares the business is broken down into. For example, JNJ is 2.73 billion shares. This is a really important number to know when you want to know what the total value of a business is being traded for. Since the current market price is $64.95 a share, we simply multiply the market price by the shares outstanding to get an idea of what the crazy traders think the value of the company is. In this case, current market traders believe the value of JNJ is $177.3 billion. As you learned in Part II of this book, that’s the market price, not the
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P/E: This is everyone’s favorite. It’s commonly referred to as the “PE.” This number is the company’s current market price divided by the company’s annual earnings per share (or EPS). Below is how you would calculate the P/E for JNJ. The current market price is: $64.95 The current EPS is: $3.48 Therefore, the P/E is the following: P/E = Price / EPS = $64.95 / 3.48 = 18.66
As a rule of thumb, Warren Buffett typically likes to find companies with a P/E lower than 15.
Dividend Rate: This is the amount of money the company will currently pay you annually for owning one share of the business. For JNJ, the current yield is $2.28. Since most dividends are paid quarterly, this money will show up in your bank account every 3 months as $0.57 per share. This number can be found on the top-level stock ticker page. Dividend Yield: This is simply the dividend rate divided by the current market price. Although this number is displayed on the top-level ticker page, it is calculated by the method below: Yield = Current Dividend Rate / Current Market Price = $2.28/$64.93
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Debt/Equity Ratio: This number is calculated by taking the company’s total debt and dividing it by the total equity. Although you can conduct this calculation on your own from the balance sheet, you can find the ratio on the top-level information page after searching for your stock symbol. For JNJ, the debt/equity ratio is listed as NA. This simply means the number has not been calculated for you. As a result, we’ll actually need to do it the old-fashioned way. In order to calculate the number, let’s start with the formula: Debt/Equity = Total Liabilities / Shareholders’ Equity
Book Value (or Book Value/Share): This number is the equity divided by the number of shares outstanding. In order to find the book value number automatically calculated, you’ll want to find a tab on the left side of your screen titled “Financial Highlights.” After clicking on that tab, you’ll notice the book value figure near the top of the screen. In order to calculate the book value on your own, you need to go the company’s balance sheet (found on the bottom left
Price/Book Value (P/BV): This ratio is a way to determine the premium investors are willing to pay over the book value (or equity) of the business. To calculate the number, use the simple equation below: P/BV = Current Market Price / Current Book Value For JNJ, the P/BV is the following: P/BV = $64.93 / $22.52 = 2.88
a simple rule of thumb, Warren Buffett typically looks for companies that possess a price/book ratio between .6 and 1.5. In order to purchase companies that have a higher P/BV, you’ll want to ensure consistent earnings are expected in the future.
Equity Growth: This was one of the top things I discussed in the second part of this book. As I mentioned earlier, be careful that you don’t review the equity growth from the balance sheet. Since the number of shares outstanding in a business change almost every quarter, simply looking at the equity on the balance sheet will not be a true indicator of the growth. The best way to review the growth is by analyzing the book value/share every year. You can find this analysis on Microsoft money by following the same path as you did for the price/book ratio. Here are the directions again: From the
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ROE or Return on Equity: In the third part of this book, I devoted an entire chapter to understanding ROE. ROE was one of Warren Buffett’s favorite numbers to look at. The easiest way to see the ROE for the past 10 years is to follow the instructions below.
From the top-level page, look on the left-side navigation bar and select “Key Ratios.” After the page builds, look at the top left side of the nested page and you should see an option to select “10-YR Summary.” After clicking on that link, you’ll see a chart that summarizes the average for a few key figures. You’ll be looking for the section titled “Return On Equity.”
Current Ratio = Current Assets / Current Liabilities
This is a great number. If the ratio was 1.0, then we would know the assets and liabilities are projected to equal each other. If the ratio was below 1.0, then the company would need to incur debt in order to continue business.
As a conservative investor, you want to ensure the current ratio is higher than a 1.5. This is typically the benchmark that Warren Buffett and Benjamin Graham liked to see in their investments.
