Quickly grasping the fundamental strengths and weaknesses of a company can save time when you are researching stocks. Narrowing the universe to a small set of names means you can be more focused and only have to dig deeper for the most promising investment candidates.

HOW TO CALCULATE THE FIVE RATIOS 

Return on equity = (net income / equity) x 100

Gearing = (net debt / equity) x 100

Gross profit to assets = (gross profit / total assets) x 100

Free cash flow to sales = (free cash flow / sales) x 100

Price to earnings = share price / earnings per share

This article reveals five ratios that can be used to get a quick understanding of the fundamental attractions of any company in five minutes.

1. RETURN ON EQUITY

Return on equity is a way to measure the performance of a company – you divide net income by shareholder equity, the latter calculated by subtracting total liabilities from total assets.

For example, pharmaceutical firm GSK (GSK) has equity of £10.59 billion according to its last audited balance sheet on 31 December 2022. This is calculated by subtracting total liabilities of £49.55 billion from total assets of £60.14 billion.

Net income in 2022 from continuing operations was £4.46 billion, therefore the return on equity was 42.1% (4.46/10.59).

With financial ratios it is more important to look at trends because any single year can be distorted by various accounting adjustments. Over the last five years GSK has delivered an average return on equity of 62%.

A decent business will have a return on equity of at least 10% and north of 15% is considered a good quality business, assuming it doesn’t deploy too much debt.

2. GEARING

Before getting too carried away with GSK’s impressive return on equity it is important to consider how much debt the company is carrying.

A useful ratio to consider is net debt to equity which is also referred to as the gearing ratio.

The attraction of debt financing is that it increases return on equity, everything else being equal.

However, increased gearing can be potentially dangerous for shareholders if taken too far as it gives more influence to banks and debt holders which have priority over shareholders.

GSK employs net debt of around £13 billion which is funding some of its assets on top of the £10.59 billion of equity funding. This implies a net gearing ratio of 123% (13/10.59).

In most cases, gearing above 75% suggests some caution should be applied when interpreting return on equity and assessing general balance sheet strength. In GSK’s case, the business tends be highly cash generative, so the firm can afford to run with higher gearing.

In addition, the company owns around £3 billion of shares in Haleon (HLN), the consumer healthcare unit spun out in 2022. These shares are likely to be sold in time. This means the underlying gearing ratio is not as high as the headline ratio.

3. GROSS PROFIT TO TOTAL ASSETS

The idea of this ratio is to measure gross profit as a percentage of total assets. A high ratio (above 40%) suggests a higher quality business.

Research by Robert Novy-Marx of the University of Rochester found the gross profit to assets ratio was more predictive for share price returns than widely used earnings and cash flow measures.

Firms with high ratios generated significantly higher share price returns than lower quality firms despite having higher valuations. Although a simple measure it is useful because gross profit and total assets are less susceptible to accounting manipulation.

Taking each side of the ratio in turn, gross profit is a basic measure of a company’s profitability. It is calculated by subtracting cost of sales from sales. Total assets represent all the assets employed in the business and can be found from the balance sheet.

Let’s look at GSK again. Gross profit in 2022 was £20.85 billion and total assets were £60.15 billion which means GSK has a gross profit to total assets ratio of 35% (20.85/60.15).

A decade ago, the ratio was closer to 45% which suggests the company has not performed as effectively in recent years. This is one of the criticisms made by activist investors including Elliott.

4. FREE CASH FLOW TO SALES

The reason for using the free cash flow to sales ratio is to identify successful and profitable businesses which tend to generate lots of cash.

Companies which can convert a higher proportion of their annual sales into cash are more valuable to shareholders than those which struggle.

The simple reason is that it gives companies more flexibility to use the cash for shareholders’ benefit. It can be used to pay out dividends, reinvest in the business to drive growth or make acquisitions.

Firms which generate more cash than they need to invest in the business can also pay down their debts which increases shareholder value.

Free cash flow can be defined as cash generated from operations minus capital expenditures. Cash from operations can be found on the cash flow statement.

Not all companies provide the same items on a cash flow statement, and it can sometimes appear a little intimidating. So, a simpler method is to look at the profit and loss statement with which most investors are more familiar.

Start with net profit and add back two non-cash items, depreciation and amortisation, to arrive at operating cash.

GSK generated £4.92 billion of net profit in 2022 while depreciation and amortisation totalled £2.43 billion which means operating cash was £7.35 billion.

Capital expenditures were £2.25 billion which means free cash flow was £5.1 billion (7.35-2.25). Sales were £29.3 billion, therefore GSK’s free cash to sales ratio in 2022 was 17.4% (5.1/29.3).

A free cash to sales ratio above 15% represents a quality business.

5. PRICE TO EARNINGS

One of the most popular ratios used to gauge a share’s attractiveness is the ratio of the share price to the forecast earnings per share for the year ahead, also known as the PE. The ratio is useful because all companies with positive earnings can be compared using this method.

The key factors driving different PEs come down to expected growth in earnings and return on equity. Higher growth and higher return on equity companies should trade on higher PE ratios.

But remember PEs can also move up and down due to investor sentiment and become divorced from fundamentals. This can throw up some interesting opportunities. Let’s compare GSK to AstraZeneca (AZN) to illustrate this effect.

GSK is forecast to deliver 146p per share of earnings for the year to 31 December 2023 and 155p in 2024. A share price of £13.91 implies a forward PE ratio of 9.5 times for 2023 and 9 times for 2024. AstraZeneca trades on forward PE of 19.8 for 2023 and 17.1 times for 2024.

That is a big difference, but is it reasonable? One way of answering the question is to look at potential shareholder returns and compare them to the PE ratio.

A rough proxy for estimating future total shareholder return is to take the current dividend yield and add expected growth in earnings per share. In theory the PE should reflect all future earnings, but in practice estimates are only available for two or three years ahead.

GSK has a yield of 4.2% and management is guiding for low-to-mid double-digit EPS growth per year over the next five years.

Conservatively assuming growth at the lower end of the range (12%) and adding the current yield implies total shareholder returns in the region of 16% a year (4.2+12).

Meanwhile, AstraZeneca is guiding for 2023 EPS to grow by high single digit to low double-digit percentages while the dividend yield is 2.1%. Analysts forecast EPS growth of 15%.

Giving AstraZeneca the benefit of the doubt because it has executed much better than GSK in recent years, and assuming it can grow EPS at 15% a year, the expected shareholder total return is 17% a year.

In other words, expected total returns for the two companies are roughly the same except investors can buy GSK shares at half the PE.

There are no guarantees that GSK shareholders will do better than AstraZeneca’s over the next five years, but the risks compared with the potential rewards looks more favourable.

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