Reading financial statements is one thing; analyzing them and deciphering their true meaning is another. To do that, you need to understand the seven essential financial ratios. They’re like a shortcut for filtering out good stocks.

The first is gross profit margin. This represents the proportion of money left over after subtracting the cost of goods sold. To calculate gross profit margin, take gross profit and divide by sales. The higher the margin, the more profitable a company is. Margins of 15% or more are considered good.

The second ratio is net profit margin. This represents the portion of money left after subtracting all expenses to calculate net profit margin divided net profit by sales. The higher the margin, the more profitable the company is. In general, look for margins of 7% or more.

The third ratio is return on equity or ROE. This measures how much profit a company makes from shareholder equity. To calculate ROE, take the net profit and divide it by equity. The higher the number, the more money the company makes for its shareholders. Look for an ROE of 15% or higher.

The fourth essential ratio is the current ratio. This measures a company’s current assets against its current liabilities. To calculate the current ratio, simply divide the current assets by the current liabilities. The higher the ratio, the more likely the company will be able to cover short term liabilities. A good current ratio is anything above 1.

The fifth ratio you should know is the debt to cash flow ratio. This measures the company’s debts against its operating cash flow. To calculate this, take the company’s total debt and divide it by operating cash flow. The lower the ratio, the better the company’s ability to finance their operations, any ratio less than or equal to three is considered good.

The sixth essential ratio is the net gearing ratio. This measures the company’s debts against its shareholder equity. To calculate this ratio, first take the total debt and subtract the company’s cash, then divide that number by the equity. The higher the ratio, the more debt and therefore risk the company has. Look for a net gearing ratio of 0.5 or less.

Finally, the seventh essential ratio is the dividend yield. This measures how much in dividends the company pays out compared to their stock price. To calculate the dividend yield, take the dividend per share and divide it by share price. The higher the yield, the more dividends shareholders receive. Look for companies with consistent yields between 4 and 7 percent.

And that’s it!

By applying these 7 essential ratios, you too can uncover hidden gems in the stock market!

Spencer Li

Spencer is an avid globetrotter who achieved financial freedom in his 20s, while trading & teaching across 70+ countries. As a former professional trader in private equity and proprietary funds, he has over 15 years of market experience, and has been featured on more than 20 occasions in the media.

To be a successful value investor in the stock market, you need to know how to identify which stocks are the most valuable. But the most valuable stocks aren’t necessarily the ones that are performing the best. In fact, the real goal is to find stocks with strong intrinsic value that are currently under valued by the market. So how do you identify these gems?

First, find the right type of business.

In general, you should always start with what you know. For instance, if you’re familiar with the technology sector, you may want to look there. Just make sure that the industry isn’t experiencing long term challenges. This will help you avoid eroding profits in the future.

Next, look for a company with a strong and sustainable competitive advantage. For instance, if a company has a patent on an emerging technology, this could help them for years to come. Finally, make sure the company has strong growth potential and a clear strategy for the future. Is there a growing demand for their product? Do they have the infrastructure necessary to expand?

Questions like these can help gauge their future success.

The second way to identify intrinsic value is to study a company’s management team.

Do some research.

See if they have the proper credentials and make sure that their skill sets are well suited for the current business climate and of course, look at their track records. Were they successful in their recent positions or did they leave those companies weaker than before? And, are they transparent with their shareholders? Executives who are open to new ideas and willing to adapt are generally more capable of overcoming future challenges.

Next, have they laid out a clear plan for future growth if not you should be concerned and how are they paid? Do they receive a flat salary or is it performance-based? And do they own a significant stake in the company? Executives who are themselves invested in their company’s success are more likely to put their shareholders first.

The third and final way to identify intrinsic value, is to analyze the company’s financial numbers.

But this topic requires a lot of attention, which is why we’ll cover it in our next video reading financial statements.

Spencer Li

Spencer is an avid globetrotter who achieved financial freedom in his 20s, while trading & teaching across 70+ countries. As a former professional trader in private equity and proprietary funds, he has over 15 years of market experience, and has been featured on more than 20 occasions in the media.