Financial math is very easy; relying on algebra in most situations, and relying on more complex statistics for very specific and unusual situations, financiers find that the majority of the calculations they make on a day-to-day basis are really middle school level, at best. What is much more important than the mathematical acumen is knowing when to use which mathematical principles and why.
At the core of most valuations in finance is the ratio, and this is especially true for equity analysis. The reason for this is that values tend to be relative of other metrics, and so you will typically want to compare two things to discover the relationship that exists between metrics.
Take, for instance, the most famous of equity valuation models: the P/E ratio. This is when you take the price of a stock and divide it by earnings. If, for instance, a stock has a share price of $100 and it earns $1.25 per quarter in earnings, it would have a P/E ratio of 20. This is all simple math, but it is also essential to understand how a stock is valued.
If you have, for instance, three companies in the same industry at different P/E ratios and the same revenue growth rate (which is another ratio, between this period’s revenue and a prior one’s), the one with the lowest P/E ratio will most likely be the best buy. However, the likelihood of this ratio being lower because of an external factor that also makes the stock less buyable is also worth considering.
This is where you would look at other factors, such as profit margins (the ratio between revenue and expenses), debt load (the ratio between debt, equity, and assets), and other aspects of the company’s balance sheet to determine why that company is priced lower. The point here is that the analysis entirely depends on ratios—very simple comparisons between two numbers that will tell the analyst what aspect of the company is being mispriced and why.
So what are the important ratios to use? P/E is one, and P/EG (price to earnings growth) is another. Debt-to-equity ratios, net profit margins, and operating profit margins are another. Free cash flow (the ratio of earnings to capital expenditures) is another important one, particularly for value investing. Growth stocks will tend to depend on simpler ratios, such as revenue growth rates and market share (i.e., the ratio between this company’s market share and others).
No one in finance uses all of the possible ratios all of the time, but knowing what they are and knowing when to use them is the cornerstone to a successful analyst. And in equity markets, a successful analyst can both make herself and her clients very, very rich.