Ratio Analysis

I have talked about the P/E ratio and how to manipulate it to predict future stock prices based on changes in earnings or multiples. What if a company does not have any earnings? Sometimes young companies are so busy selling and developing products that they are not yet profitable. Usually these are smaller companies with limited resources to accomplish profitability yet. This can be a rich area to mine for investment. So how do we analyze such companies? Another tool in the Ratio Analysis tool box is the Price/Sales ratio. This ratio is best used as a comparison with other companies in the same business. If nothing else, it can give the investor an idea if the stock price is too high compared to other businesses. What this ratio is telling you is how many dollars you are willing to pay for $1 of sales in this company. The hope here is that if sales growth is high, then earnings are soon to follow.
     Another ratio that may be used is the Price/Cash flow. Cash flow may also be expressed as EBIDTA which stands for earnings before interest, depreciation, taxes and amortization. Sometimes, companies have a lot of depreciation which clouds the earnings picture. This accounting measure cuts through the crap to determine whether this company can actually pay its bills.
     As a conservative investor, I like to stick with established companies with a long record of earnings and increasing dividends. However,  I also recognize that the really spectacular growth comes from young companies on the cutting edge. This is why I bring up these two ratios. I would only consider a small portion of my portfolio in these small-cap names. That being said I would point out that late in a bull market, small caps tend to outperform the large cap stocks. The current bull market in stocks is over 7 years old, nearly a record. I usually invest in small caps through mutual funds because the names in this space are unfamiliar to me and I don't have time to sift through the hundreds of stocks to identify potential winners. Sometimes its best to leave the heavy lifting to the pros. My next post will be about investing in mutual funds. Its not as simple as"investing and forget it". I will talk about pitfalls that should be avoided.