Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice, including how to use financial ratios. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “How we use financial ratios to spot bargain stocks.”

If you want to shop for bargain stocks, it’s best to focus on shares of high-quality companies that have a history of sales and earnings, plus a strong hold on a growing clientele.

Bargain stocks like these are rare and hard to find. But they do turn up from time to time. Here are 3 financial ratios that can help you spot them:

1. Price-earnings financial ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. Generally the rule is that the lower the p/e, the better, and a p/e of less than, say 10, represents excellent value.
   
   We calculate each p/e ratio using the most recent financial data. But we also analyze the “quality” of the earnings. This means for instance that we disregard a low p/e ratio if it is due to a one-time capital gain on the sale of assets, since the gain temporarily bloats the “e”. (That shrinks the p/e.) Similarly, we add back any one-time earnings write-offs, so we don’t miss out on bargain stocks that would have had low p/e financial ratios, if not for one-time write-offs.
   
   You need to remember that a low p/e can be a danger signal. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why it’s crucial to view p/e ratios in context. Instead, we check to see if other financial ratios confirm or contradict their value.

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2. Price to book value financial ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value. This financial ratio represents a “snapshot” of an instant in time, and could change the next day. Asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation. (Certain types of assets on a balance sheet might have actual market values well above historical values, as sometimes happens with real estate or patents.)
   
   When we find a stock with a low price-to-book value, we look to see if the price is too low, or if the book value per share is inflated. Often, it’s because the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, and at risk of being written down.
3. Price-cash flow financial ratios: Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is really a measure of the cash flowing into a company less cash outlays.
   
   Simply put, it’s earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. Cash flow is particularly useful in valuing companies in industries where depreciation and depletion charges are based on the historical value of assets, rather than current values — industries such as oil & gas and real estate. Of course, you have to look at it in context, as with any financial ratio.

The overriding factor: The quality of the bargain stock’s business

Once we’ve found a company that looks attractive using the financial ratios detailed above, we look to see if it has a solid business in an attractive industry, with a history of sales and earnings, if not dividends.

A stock with attractive financial ratios can stagnate if the company or its industry is in a difficult period. But if it’s a high-quality company, it’s likely to hold up better than other valued-priced alternatives. Moreover, it may be first to move up when conditions improve.

Next Wednesday, May 4, 2011, Investor Toolkit will give you our advice on price-to-sales, a lesser-known financial ratio we also use when picking stocks.

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