Welcome to Microeconomic Analysis! In this video, you will learn fundamental analysis at the company level, financial statement analysis, and financial ratios and their interpretation.

Overview

Microeconomic analysis is used in the evaluation of individual stocks or corporate bonds. The term refers to the analysis of the economic well-being of a financial entity, as opposed to only its price movements. Traders analyze the financial statements of a company in order to decide if its stock is a good investment. Questions traders ask may include “Is the company's revenue growing?”, “Is it actually making profits?”, “Is it able to repay its debts?”, and “What is the fair value of its stock?” In the long run, a stock’s price is driven not only by a company’s ability to grow sales and earnings, but also by the economic conditions. Many companies have seen their earnings fall because of a downturn in the economy and consequently, the prices of their shares.

Financial Statement Analysis

Traders analyze financial statements of a company in order to decide if its stock is a good investment. The balance sheet, income statement, and cash flow statements reveal the financial makeup of the company. The balance sheet compares the company’s assets like cash, equipment, and property, to its liabilities or debts and owner’s equity, which is the capital employed by the owners. The balance sheet explains to us how the company raises money in order to acquire its assets and how much of this money is raised through debt and equity.

The income or profit and loss statement reveals how the company earns money. The cash flow statement shows how the company uses its cash to operate the business and how much is borrowed from banks or bond holders. In the profit and loss statement, expenses, such as operational expenses, interest expenses, or taxes, are deducted from the company’s total revenue to show us the firm’s net profits (earnings). The higher the company’s net profits, the bigger the returns for the owners – which is reflected in dividends shareholders will receive. The higher the profitability, and hence the dividends of a company, the more attractive the company becomes.

Financial Ratios

P/E Ratio

On the valuation side, out of several investment valuation ratios, the most commonly used is the P/E ratio. Since price alone doesn’t show the value, this ratio compares the price of the company’s share to the amount of earnings it generates. This ratio is calculated by dividing the price per share by the earning generated per share. It provides investors with a quick idea of how much they are paying for each $1 of earnings. Investors should compare the P/E ratio of one company to its competition – from then, they can determine the best shares to invest in. Hint: it’s those with the lowest P/E ratios.

Dividend Yield Ratio

When a company earns profits, it can reinvest the profits into the business, called retained earnings. The part of the profits that is not retained is distributed as payment to shareholders, called dividend. A stock's dividend yield is calculated as the company's annual cash dividend per share divided by the current price of the stock. Dividend yield measures the number of years it will take before you can get your initial investment back.

If you pay $100 for a share, and it has a dividend yield of 10, assuming this will remain constant, you will need 10 years to get back your initial investment. Investors compare the dividend yield ratio of one company to its competition. The best shares are those with the highest dividend yield ratio.

Liquidity Ratio

Liquidity ratios look into the ability of a company to pay its debts and still fund its ongoing operations. It is simply calculated by dividing the current assets over the current liabilities. The current ratio reveals whether a company has enough cash to pay off its short-term liabilities. A low liquidity ratio means the company does not have a lot of available cash, which could hinder its operations. Investors compare the current ratio of one company to its competition and the best shares are those with the highest ratio.

Return/Proftitability Ratio

Return ratios display the company’s ability to generate profits. The return on assets ratio (ROA) illustrates how well the company is employing its total assets to make profits – the higher the return, the better. It is calculated by dividing the net income of the firm over its total assets. Another profitability ratio is the return on equity ratio (ROE) which measures how much the shareholders earned for their investment in this company – the higher the ratio, the better. Return on equity divides the net income by the shareholder’s equity or contribution. Investors compare ratios of one company to its competition and the best shares are those with the highest ratio.

Debt Ratio

Debt is a very important element in the evaluation of a company. The debt ratio compares a company's debt to its assets in order to know about the level of leverage. In essence, the lower, the better. The debt ratio is calculated by dividing total liabilities by total assets – lower values reflect better situation for the firm. The debt-equity ratio measures how much creditors have committed to the company versus its shareholders – a low percentage means low leverage. It is calculated by dividing the firm’s total liabilities by the shareholders equity. Investors compare ratios of one company to its competition and the best shares are those with the lowest ratios.

Conclusion

Among the dozens of financial ratios available, we've only covered a few. There are other figures to examine in financial statements but what’s been covered so far can give you a good idea about the share you want to invest in. However, it is essential to research more about fundamental analysis and use it for future educated trading decisions.

Recap!

In the next video, we will talk about technical analysis. Thank you for watching!