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Best Financial Ratios to Compare & Analyze Retail Companies in the Nigerian Stock Market – Learn the Most Important Ratio Investors Use to Pick Stocks.
Stock market investing isn’t a process of jumping at any company’s shares because you love the brand or are personally attached to the company’s chief executive or even have a relative working in such company but one that requires a careful analysis of the financial position of a company with the aim of ascertaining its future growth potential. This is generally done by looking at the company’s statement of income or profit or loss, understanding its strength via the statement of financial position and cash position on the statement of cash flow.
The truth about analysing a company’s financial strength is that you don’t have to be a financial guru, professional analysis or an experienced stockbroker, all you need to know and understand are few numbers that intuitively revealed the past performance and where the company is headed.
Personally, I work with few reliable financial ratios before taking investment decisions. In using these ratios, do not randomly pick a stock and then subject it to these ratios, go to the post, where I shared profitable strategies to selecting best-performing stocks to screen out top stocks in the strongest sectors.
One great reason you shouldn’t ignore financial ratios when investing is that when you have several stocks to buy, it helps you to easily compare and pick the best companies with attractive growth potentials.
I have already discussed the application of these financial ratios using Transcorp and Dangote financial statement as at 31st, Dec 2017, click here
Now, let’s talk about these financial ratios as it relates to growth, opportunities and share price forecast.
1. Growth
When analyzing or comparing two companies, the first major area to look at is how fast each of the stocks is growing. Here, I look at financial ratios like market share ratio, the cost to sales ratio, gross profit margin, interest coverage, and net profit margin.
Market Share
The market share ratio of a company lets you see what percentage of the customer market the company currently occupies? a company may earn N6bn from the sale of its product in a current year against N5bn the previous year, representing 20% increase and at the same time lose its market share to competitors. How do you calculate the market share of a company? Divide the company’s sales by the sales of all the companies in the industry.
For instance, if company A, B, C and D in the food and beverage industry make a sale of N10bn, N15bn, N5bn and N5bn respectively, the cumulative sales figure will be N35bn. To calculate the market share of company A, divide N10bn by N35bn; 28.5%.
The market share of company A is 28.5%, now assuming the company revenue last year was N5bn and market share was 40%, would you say the performed well? No, even though, sales grew by 100%, they are losing market share to competitors faster which is a potential threat to long-term growth. But, if sales grew in line with market share number year-on-year, we can then conclude that they have a competitive advantage which may be a result of brand loyalty, aggressive market penetration strategy etc.
Cost to Sales ratio
Every company incurs costs before making money, so, it wise to check the Naira incurred on sales of a product for different companies as this will help you uncover the company that is most efficient on resource utilization. The cost to sales ratio help you see what percentage of the sales figure is attributable to input cost, an increasing figure means the company is spending more to earn money which a decrease indicates that the company is spending less to earn more.
You will find the cost of sales as a line item on the statement of profit or loss and other comprehensive income, below the revenue or sales figure.
The cost of sales ratio is derived by dividing the cost of sales by the sales figure. If a company A’s sales increased from N100bn to N500bn and cost of sales grew from N50bn to N350bn, the cost to sales ratio will 50% and 70% respectively. Such increase, despite significant sales growth, reveals inefficiency in operation.
Gross profit margin
This ratio lets you check the profit earned on every Naira sales made after deducting the cost of sales. It is calculated by dividing the gross profit (sales – the cost of sales) by sales figure.
Using the example above, gross profit of company A will be 50% (N100bn – N50bn/N100bn), which is lower than the current margin of 30% (N500bn – N350bn/NN500bn).
You can see why I said the company isn’t efficient despite the 5X growth in sales. A great company should explore its competitive advantage, which could be via price increase or cost savings, to make more money.
Interest coverage
A lot of investors ignore this useful ratio when comparing companies and picking stocks. Every company issues debt securities and as such is required to pay interest on these debts, otherwise known as the finance cost. The only cash that’s expected to cover this cost comes from operational profit (earnings before interest and tax is paid). When the debt keeps increasing, it also drives the interest payable higher, so smart investors look at how many times a company is able to cover the growing interest to avoid buying into stocks that could be adversely affected by exposure to credit risk or exchange rate loss on foreign borrowings just like Transcorp plc in 2016.
The interest coverage ratio divides the profit from operation (EBIT) by interest expenses and a lower number compared to the previous year/quarter indicates a good company.
Net profit margin
The net profit margin lets you see the percentage of sales that are available as distributable profit to shareholders after all expenses, including tax and admin expenses, have been accounted for. This is where you look at the profit after tax figure and divide it by sales. I love to see a company grow its netprofir margin by 10% or more.
2. Opportunities
After I analyze the growth potential of my stocks, I also look at the abilities of these companies to finance opportunities without borrow or incurring more debt. The two ratios I look at is the debt to equity and return on equity.
A company that wants to grow and reward shareholders’ isn’t supposed to pile up debt that eats into its profit more than it pays a dividend to shareholders.
The debt to equity ratio compares the long-term debt of a company to its total equity to ascertain how exposed the company is to external debts. The lower the better and higher it is, the higher the interest expenses and lower the interest coverage ratio.
If a company is able to lower its debt, it surely will reflect in the interest expenses and hence, drive profit too. The profit after interest, tax and admin expenses represent the redistributable earnings to shareholders when you divide this by total shareholders’ equity, then you have the return on equity.
Shareholders love to see a company that is increasing its return on equity year-on-year.
Summarily, I love companies that had been reducing its exposure to debt and at the same increasing return on equity which means, it’s able to finance future growth opportunities with cash generated from operating activities.
3. Share price forecast
After analysing the performance of your potential stocks, it isn’t great idea to jump in because the growth and opportunities ratios tell you that the company is doing well, I like to take advantage of cheap growth stocks which aren’t stocks that are below N10 but stocks whose earnings growth is driving the current market price upward.
If you are looking for low-priced stocks with growth potential, click here
The two ratios that help me buy at a cheap price are price-earnings and PEG ratios.
Price-earnings ratio tells us how much investors are currently paying for a company’s stock. A high figure means that traders are betting higher on the company compared to its peers while a lower figure means, the stock isn’t rising fast as it could.
I really don’t use PE ratio in isolation, you can compare it with other company’s PE to check for perception and divide it by the company’s expected earnings growth rate. The expected earnings growth is subjective and as such shouldn’t be over-estimated based on a current year’s growth.
The PE ratio divided by the expected growth rate will help you know a truly cheap growth stock. Even if the PE is the highest in the industry, as long as investors’ or analyst’s perception of the company’s growth rate is largely positive, the share price will still soar higher. It all boils to the overall economic outlook and industry investors are putting more money.
That’s all for now on the best financial ratios to analyse and compare companies in the retail industry. If you need a more expandable and practical approach to explore the Nigerian stock market, then get my video on “Top Gaining Stocks“
